• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

Aarati Krishnan

WHAT do you look for when you choose a mutual fund from many competing offerings? The fund's track record, its recent performance and the credentials of the fund house and fund manager, right? It is now time to add fund expenses to that list.

Fund expenses are not yet a big issue with equity funds. But they could make a significant difference to your returns from debt and hybrid funds.

Investment advisors in India generally downplay the importance of a fund's expense ratio when choosing a fund. There is some justification for this. In America, fund managers have a harrowing time delivering returns that are even 1-2 per cent higher than the market, on a sustained basis. But the majority of Indian funds — both equity and debt — have historically beaten the market they track by a wide margin.

If a fund manager is truly adding value through superior returns, what is harm in the fund charging me more for it, you may ask. Here is why you now need to pay more attention to fund expenses.

Making a dent in bad times

Remember, a fund charges expenses irrespective of whether you, as an investor, have had a good or a bad year. An expense ratio of 2.5 per cent for an equity fund or 1.5 per cent for a debt fund, may not look particularly daunting in a year where the average equity fund has delivered a 90 per cent return, or a debt fund a 16 per cent return.

But would you take the same view if you knew that your fund's expenses are taking away a fourth of your returns for the year? They could now, for debt funds. With trading gains from falling interest rates evaporating, returns on plain debt funds averaged returns of 5-5.5 per cent in the past year.

The half-yearly accounts of funds show that expenses took away about 1.3 per cent of the net asset value for the average debt fund. But the expense ratio varies widely between funds. Based on their accounts for the half-year ended March 2004, for the most expensive debt funds, the expense ratio lopped off over 2 per cent of the net asset value this year.

For the least expensive fund, the expense ratio was a mere 0.6 per cent. This means that from the same bond portfolio which yields 5.5 per cent, the low-cost fund would earn you a 4.9 per cent return but an expensive one could leave you with returns of just 3.5 per cent!

Not an issue yet, for equity

For the same period, equity funds sported an average expense ratio of 2.1 per cent, with expense ratios ranging between 0.9 per cent and 2.5 per cent. Even an expense ratio of 2.5 per cent may not make a big difference to returns from an equity fund, if it continues to outperform the market significantly.

Seven of 10 actively managed funds have done this over the past five years. But since expenses have a compounding effect on returns, this could change over the long term if returns from equity funds revert to mean, and fall in line with long-term equity market returns of about 10-12 per cent.

Price tag has nothing to do with performance

Then, there is the fact that a higher price tag does not necessarily get you better performance. For one, only half (sometimes less) of the expenses charged to you by a fund go to pay the fund manager's fee. The rest goes mainly to meet brokerage, selling, distribution and investor communication costs.

Second, the most expensive funds are not necessarily those with the best track record. Nor are the funds with low expense ratios lemons. While you may be willing to shell out more for a fund which trounces the market by a wide margin, would you do the same for a fund which trails it by a mile?

For instance, Franklin India Bluechip Fund, one of the top-performing equity funds, has generated an annual return of 27 per cent over the past five years and charges an expense ratio of 2 per cent. Whereas, JM Equity Fund with a 9 per cent annual return over the same period, has an expense ratio of 2.5 per cent.

There are several such instances within the universe of debt funds as well. Tata Income Fund charged 2.13 per cent in the half year ended March 2004; after returning 10.1 per cent annual return over a five-year period. But Templeton Income Builder Account, with a lower expense ratio of 1.64 per cent, managed a much better 12.5 per cent return over the same five-year period.

In fact, there may actually be an inverse relationship between the expense ratio and performance. Statutory requirements peg a fund's expense limits to the size of the assets managed by it.

In the open-end format, funds which turn in a good performance usually add assets very quickly, which in turn trims their expense ratio. Less impressive performers remain small-sized, and expenses take away more of their returns!

Choosing funds based on expenses

Granted, you have to compare fund expenses when you choose from different funds within the same asset class. But in some situations, the expense ratio may also influence the class of fund you should invest in. Here are a few observations based on the present expense ratio structures:

Advantage short-term debt funds: Based on their potential yields and expense ratios, debt funds which invest in short term instruments may, in the near term, provide better returns than plain debt funds that invest in long-dated corporate bonds and gilts. Here is why.

As capital appreciation from long-term bonds is no longer possible in a stable or rising interest rate regime, returns from debt funds will hinge mainly on the interest receipts on the bonds carried in their portfolio.

The portfolio yields on short-term bond funds are at present slightly lower than those on plain long-term debt funds. But this is more than made up for by their much lower expense ratios.

The bond portfolio of Templeton Income Builder Account, a typical debt fund, now carries a yield of about 5.85 per cent, before fund expenses. At an expense ratio of 1.75 per cent, this would mean an effective return of 4.1 per cent for you as an investor. But Templeton's Short Term Income Fund boasts a portfolio yield of 5.57 per cent, with an expense ratio of 0.90 per cent. The fund may actually earn you a higher effective return of 4.7 per cent!

Floaters and liquid funds: Their low expense ratios also make floating rate funds a good investment option, for the same reasons. Floating rate funds carry a lower risk profile than plain debt funds; as their capital values are unlikely to be singed by a spike in rates.

At present, the average floating rate fund charges an expense ratio of 0.86 per cent — pretty low when compared to that of a plain debt fund, which charges about 1.3 per cent.

Liquid funds may also offer a good bargain, if you are risk-averse. Expense ratios for liquid funds hover between 0.3 per cent and 1.1 per cent.

Hybrid funds, a pricey option: The expense ratio may have an important role in determining returns from hybrid fund products such as MIPs and balanced funds. The expense ratio for the typical balanced fund is 2.1 per cent. This is high considering that balanced funds invest 30-40 per cent of their portfolios in debt instruments.

This means that the debt portion of the balanced fund's portfolio, which will earn a modest return of 5-5.5 per cent, will get saddled with an expense ratio of about 2.1 per cent — the same as the equity portion. This can make a significant dent in your overall returns. This may not be too apparent as long as the equity portion delivers stellar returns, but will begin to pinch if equity returns nose-dive.

Given its larger debt component of 80-90 per cent, expenses can be even more of a burden in an MIP. Be sure to compare the expense ratio of any hybrid fund to the option of directly investing in the respective fund classes, before you settle for the former.

"Fund of fund" products, which allow you to channel your money into existing debt or equity funds may be a good alternative to get around the high expense ratios of hybrid products; but check out their management fees first.

Index funds: If expense ratios can influence returns for actively managed funds, they can make or break returns from passively managed index funds. Surprisingly, there is a wide divergence in expense ratios even within the universe of index funds.

For the half-year ended March 2004, index funds disclosed expenses ranging from 0.5 per cent of the net asset value (for UTI Sunder), to 1.6 per cent of the NAV (for Principal Index Fund). Faced with such a choice in the case of index funds, go for the one with lower costs, after factoring in loads and sales charges that also add to your costs.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Investment Quiz

Copyright © 2004, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line