January 04, 2006

Expense Ratio... Who is looking when investing

When advising people on Mutual Funds, I always saw people looking at few parameters for investing. The first was always 'Returns'. To me this is extremely important, however I found this an extremely narrow minded approach to investing. When advicing we had to specify reason for investing in a scheme. So, in my first few months, one parameter I explained was the 'Expense Ratio'. This is the ratio a fund is being charged for the services offered by the fund house to manage the fund and this does not refer to the normal 'entry or exit load' which most investors are aware of. My customers were quick to shoot this down and look at the return and which area was it investing. If they were comfortable with the idea, the investment was completed and I return happy. Over a period, I too stopped explaining and preferred to explain only if the demand needed. The sad part was after a two years, I stopped looking at it. Only after I shifted my jobs, did I start looking at it closely and I was surprised to see what was happening.

To understand this ratio you need to understand where is the money being made by a fund house. Though mutual fund is formed as a trust, the underlying objective for any mutual fund company is 'Profit'. Fund houses make money on the expense that is charged to their schemes. So, in effect the more the company has assets, the more it makes money. In India, fund houses are regulated with the amount of expenses that it can charge. It differs based on two factors:
  • Type of Product being offered
  • Size of the Scheme
Deploying money is more time consuming in equity schemes than in debt schemes, considering the risks associated with the market. Infact, for debt schemes, there is hardly any incremental cost in deploying higher amounts of money. Hence the equity schemes are allowed to charge 0.25% higher than a debt based scheme.

As it is easier for higher amounts of money to be deployed with no huge additioanl costs, fund houses are given ceilings for the expense that it can charge based on the assets that it has in the scheme. The charges are

  • first 100 crores-2.5%
  • the next 300 crores - 2.25%
  • the next 300 crores - 2%
  • the rest - 1.75%
Now that you know the charge, lets see the current practise. It ranges from 0.75% for a liquid scheme to 2% for long term products. Unlike banks, mutual funds are forced to match the duration of its investments with its clients investment horizon. That is investors with a shorter time frame invest in cash schemes that has very short maturity periods. Since investors, mostly institutional investors, invest for less than a month, they do not want to see any negative returns on investment. So, investments are made in products with a similar time-scale and these products normally give lesser returns. As the investor, has the option to invest the same in a bank fixed deposit, the only way to provide similar returns is by reducing expense. The second reason for charging this low fees fund houses have similar bond portfolios. As this will only generate similar returns, they differentiate with expense ratio, as this will directly boost the returns. The underlying assumption is that charging a slightly lower expense ratio will generate more assets to manage.

However, this situation is completely reversed in equity schemes. Fund houses can differentiate themselves with better stock picks. So here we see most fund houses charging the maximum possible expense on the fund. This is where I find it unfair to the investor. The investor pays a load for entering the fund. Over this amount, he is charged with another 2.5% charge. This makes the investor to lose 4.75% on every investment that he makes. Also, this is under the assumption that the investor is for a year. Also, the current practise to churn the portfolio for better returns by moving to different schemes further worsens the matter. Though the expense is not a one time charge, a customer who shifts his portfolio twice a year ends up losing 6.5% p.a. This is a phenomenal charge, considering the returns that he makes.

The investor is least bothered of this issue today. With equity markets flaring, he is making a lot of money. Agreed that this returns is better than most asset classes but is the customer making the most of his investment. The investor has taken a risk by entering this product and the fund houses charge a load as 'fees' to give to the broker who brokered this transaction. The broker ensures that the fund being sold is always a load fund. Sometimes, fund houses remove this load for higher amounts. On most occasions, this would never be revealed to the customer. After this the customer is not aware of the expense charged on the fund. He assumes that the poor returns is always because of the poor stock picks. For this, I shall not blame the broker. I have tried to teach this to my customers and they are rarely interested in it. Hence, we see this practise by fund houses to charge as much as possible.

In the U.S. fund houses such as Vanguard, thrive on reducing the costs for a product and pass the benefits to the customers. The bonus for the employees are based on the costs that it has saved. We hardly find such a practise in India. Even if it followed like in cash funds, it is more with a reason to accumualate more assets than anything else.

I believe that this situation can be changed. Though it would take a long time. Firstly, fund houses have to change their way of operations. Mutual funds have gathered a good momentum this time in gathering assets in the current market. However, this is comparitively low when we look at its participation in the equity market. To improve this funds have to make the fund attractive, a reduction of expense is necessary as this automatically improves the customers returns. Also, the load factor. The fund have to start lowering their load as this prevents most customers to enter a fund. NFOs with 'no load' have been successful in the past. Though the fund houses had to burn their money to pay the broker, it showed the success of such ventures.
It is difficult to implement considering the nature of the distribution. If one was to look at the long term prospects of this industry, I believe this practise has to be established.

Secondly, Fund houses regularly interacts with its customers. The mailers it sends on its products can show the expense it charges. Sadly, today except Franklin Templeton, I do not see this practise elsewhere. Repititive information on expense is bound to create some interest. Agents may not like the direction this might lead, however I believe this will be good for the industry in the long run.

However small this issue maybe for the industry, I am concerned. As an optimist, I strongly believe this product to have the potential of being the most important channel for investing our savings and I do not want to see a bad landing as it has happened a few year back.

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