What can drain your gains

Mutual fund returns matter, certainly, but do track their expense ratios too

Mutual fund investors usually focus on ‘returns’ and seldom look at costs — popularly known as ‘expense ratio.’

But expense ratio is as important as returns in a mutual fund, given that higher expenses can eat into funds’ returns over the long run.

Here’s a look at what constitutes expense ratio and ways to understand the norms laid down by SEBI that cap such expenses based on the type of fund.

Mutual funds typically incur two types of expenses. One is non-recurring expenses that are incurred during the launch of a fund. These expenses are borne by the fund house and not charged to the investors.

The second is recurring expenses — fees and expenses charged for managing the scheme.

It includes investment management and advisory fee, trustee fee, and marketing and selling expenses. These expenses are calculated against the daily average net assets of the fund.

The NAV of each day is actually calculated after accounting for such expenses and hence, borne by the investors.

Cap on expenses

Under the existing norms prescribed by SEBI, mutual funds are allowed to charge a maximum recurring expenses or total expense ratio (TER) of 2.5 per cent of the fund’s net assets in case of equity funds.

The cap is set lower for debt and index funds at 2.25 per cent and 1.5 per cent, respectively.

SEBI guidelines further specify the limits of TER based on the size of the corpus.

For equity schemes, fund houses can charge 2.5 per cent for the first ₹100 crore, 2.25 per cent for ₹100 crore to ₹400 crore, 2 per cent on the next ₹400 crore to ₹700 crore and 1.75 per cent on above ₹700 crore. For debt, the limits are 25 basis points lower for each slab.

However, it is very likely that you may have come across a fund that has an expense ratio far higher than the prescribed caps. This is because, an additional 30 basis points can be charged by the mutual fund if the inflows come from beyond the top 15 cities; another 20 basis on other permissible expenses.

Fund houses can also charge for the service tax on the management fee. Hence, an equity fund with a corpus up to ₹100 crore may end up charging an expense ratio upto 3.3 per cent.

It is worth noting that the securities transaction tax (STT) that a fund pays while churning its portfolio does not form a part of TER as per SEBI norms. However, investors have to cough up STT while redeeming their units at the rate of 0.001 per cent of total proceeds.

Some charge more

According to the latest expense ratio data (source: NAVIndia and ACEMF), there are about 34 funds, including close-ended schemes that charge higher expense ratio of more than 3 per cent, for instance, Baroda Pioneer Large Cap Fund (3.26 per cent), Sundaram World Brand Fund-Sr III (3.04 per cent) and DSPBR Technology.com Fund (3.02 per cent).

While the higher expense ratio in some cases can be justified by their lower asset base (less than ₹100 crore), some others such as IDBI Prudence Fund (corpus ₹326 crore), IDBI India Top 100 Equity Fund (corpus ₹439 crore) and DSPBR Natural Res & New Energy Fund (corpus ₹197 crore) that have higher corpus also sport higher expense ratios of 3.12, 3.08 and 3.08 per cent respectively.

Investors have to be cautious while investing in close-ended funds as many of them charge relatively higher expense ratios than their open-ended counterparts.

For instance, the average expense ratio of the close-ended equity-oriented funds as of March 2017 was 2.7 per cent while it was 2.4 per cent for open-ended equity oriented funds.

Varying expenses

Among funds with larger asset bases, Franklin Build India Fund (corpus ₹873 crore), ICICI Pru Select Large Cap Fund (corpus ₹754 crore) and MOSt Focused Midcap 30 Fund (corpus ₹1,305 crore) charge relatively higher expenses of 2.8, 2.65 and 2.57 per cent respectively. Meanwhile, funds like Quantum LT Equity Fund (corpus ₹730 crore), ICICI Pru Focused Bluechip Equity Fund (corpus ₹12,843 crore) and DSPBR Focus 25 Fund (corpus ₹2,267 crore) charge relatively lower expenses of 1.25, 1.67 and 1.75 per cent respectively.

Go direct

The markets regulator made it mandatory for mutual funds to launch ‘direct’ options in late 2012. Since there are no commissions to be paid to intermediaries under this route, the expense ratios of direct plans are notably lower than of ‘regular’ plans.

Savvy investors, who can cherry pick mutual funds on their own, can opt for direct plans. Remember though, that the expense ratio should not be your only criteria for choosing a mutual fund. A sound track record of consistent returns is critical to achieving your long-term financial goal.

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