Are mutual funds’ TER charges for investors too high?

The cost of investing in mutual funds in India is generating much debate between distributors, fund houses and industry participants. A 2017 report by Morningstar found India amongst the most expensive when it came to expense ratios of equity and allocation funds.

This was refuted in a study by the Foundation of Independent Financial Advisors which concluded that India ranks third lowest in terms of cost structure relative to comparable geographies. This debate will likely rage for some time, but investors should be aware of the costs they incur.

How funds should charge

Mutual funds are among the most transparent vehicles when it comes to cost structure. The entire cost of buying a particular scheme is stated upfront in the form of the total expense ratio (TER). Computed as a percentage of the total assets of the scheme, it includes the costs incurred towards administration, distribution and management, among other things.

The direct plan variant excludes the distribution cost, and therefore costs lower than the regular plan. This cost is recovered from the investors on a daily basis, and the scheme’s net asset value (NAV) is arrived at after deducting this amount.

Mutual funds can charge expenses within the limits prescribed by the regulator, which varies according to the corpus of the scheme. The maximum TER allowed is 2.5% for the first Rs 100 crore of average weekly total net assets, 2.25% for the next Rs 300 crore, 2% for the next Rs 300 crore and 1.75% for the rest.

For debt funds, the initial limit allowed is 2.25%, which progressively drops to 2%, 1.75% and 1.5%. Funds until recently were allowed to charge 30 bps extra as incentive to penetrate smaller towns and an additional 20 bps in lieu of clawback of exit loads. Sebi tweaked the rules to allow funds to charge the additional 30 bps only for mobilising assets from beyond the top 30 cities while also cutting down the additional expense charged in lieu of exit load to just 5 bps.

What funds actually charge

It is pertinent to note that the mutual fund industry’s asset base has grown significantly over the past few years, which ideally should be driving down costs. Yet, the reality is very different. Our analysis of the cost structure of all diversified equity schemes over the past year reveals costs have hardly budged. While the asset base for the 172-odd schemes has expanded by around 20% to Rs 5.42 lakh crore at the end of June 2018 from Rs 4.53 lakh crore in July last year, only 91 have lowered the TER.

While 33 schemes have lowered TER by more than 20 bps, another 29 schemes have hiked the TER by more than 20 bps. If growth in the asset base is factored in, of the 116 schemes that grew in size during this period, as many as 44 schemes have hiked the TER. From this basket, of the 62 schemes that have seen assets jump by more than 25% since July 2017, 22 schemes have hiked the TER. Ten of these have hiked the expense ratio by more than 20 bps.

Of the 37 schemes that have witnessed corpus swell by more than 50%, 10 have hiked the TER, of which five have increased it by more than 20 bps. In fact, some schemes with a smaller kitty are charging more than 3%. A part of the hike in TER can be attributed to the higher GST of 18% compared to the 15% service tax earlier. However, weighing the costs according to the size of each scheme, the average TER for the entire basket of diversified equity schemes has remained at 2.19% over the two time frames.


Source: Ace MF Compiled by ETIG Database.

Scope for lower cost?

So are investors getting a fair deal? The broader sense is that funds are not entirely passing on the benefits of the rapid growth in assets over the past few years. Suresh Sadagopan, Founder, Ladder 7 Financial Advisories, says, “Many fund houses seem to be adhering to the law in letter; but it needs to be adhered in spirit. The cost structure has scope to be rationalised considering the phenomenal growth the industry has experienced.”

Aditya Agrawal, MD, Morningstar India states, “We believe as assets under management grow, asset managers should focus on passing on the benefits of economies of scale to investors by reducing expense ratios.”

Some reckon the value proposition to the investor justifies the costs. Radhika Gupta, CEO, Edelweiss AMC, argues, “Equity funds have largely been successful in delivering healthy alpha, net of fees, to the investors.” However, she admits there is scope for lowering costs in some segments.

A. Balasubramanian, CEO, Aditya Birla Sun Life AMC and Chairman of Association of Mutual Funds of India, insists reduction in expense ratio is not warranted. “Overall penetration of mutual funds continues to be low. Reducing expense ratio is not a solution as there is a long way to go to achieve a wider reach.” He adds that the recent shift in criteria for allowing additional 30 bps charge only beyond top 30 cities along with shaving off of 15 bps from exit load charge will soften expense ratios by at least 18-20 bps going forward.

Srikanth Meenakshi, Founder and COO, FundsIndia, concurs, “Rationalisation of costs cannot be done at the cost of growing the industry’s market.” He says the earlier cost structure enabled AMCs to expand footprint, spread awareness and increase market depth. After the clampdown, they will now find themselves with lesser resources to do such activities.

Fund costs are critical because they can eat into the returns over longer periods of time. Even a 25 bps variation in costs can make a big dent in the corpus it generates. For instance, if Rs 5 lakh is invested in two funds delivering 12% return over 20 years, the fund charging 25 bps lower expense ratio will generate Rs 2.1 lakh more.

While investors have the option of avoiding higher costs by opting for cheaper direct plans, most lay investors will be better served if they can access cheaper regular plans with advice. Meanwhile, Sebi has taken cognizance of the matter and indicated that it will soon examine the existing expense ratio applicable for various schemes.

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