If a fund performs well, marginally higher costs are well worth it. If it doesn’t, you must not invest in it in any case.

This question will seem almost blasphemous to anyone who has been reading up about mutual funds on the Internet.

In the US and most other developed markets, advisors and columnists make strenuous arguments to convince investors that costs are a critical factor to consider while choosing mutual funds.

They will also offer you calculations to show how even a small blip in costs affects your returns.

Different markets

But costs are certainly not one of the top factors that Indian investors should worry about while choosing funds. This particularly applies to equity funds. There are many reasons for this. For one, the absolute level of returns that Indian equity markets usually deliver is much higher than in the US. For instance, equity funds in India are expected to deliver at least 15 per cent a year to justify their risks.

Funds that have been around for 10 years or more have in fact delivered an average return of about 22 per cent a year.

As against this, the annual expenses of equity funds range between 1.5 per cent and 2.5 per cent. A difference of 1 percentage point in expense ratio between two funds makes little difference to overall investor returns.

Two, fund houses in India, unlike in the US, cannot charge vastly different expenses or costs for similar products.

The Securities and Exchange Board of India limits the annual expense ratio that any scheme may charge to unit-holders at 2.5 per cent of assets. The charges reduce progressively as fund size increases. Entry loads, or upfront charges on buying units, are completely banned.

Manager matters

In contrast, in the US, there is no regulatory cap on annual expenses. Entry loads on funds can go up to 8 per cent of the NAV. This allows room for fund houses in the US to differentiate their products on costs, which Indian funds can’t.

Three, in the US the case for buying low-cost funds is often made on the premise that the majority of active equity funds don’t outperform the market.

Why pay a manager any extra fee for active management, when you can get the same return through an index fund or exchange-traded fund?

But in India, active management does make a big difference to equity returns. The top-performing equity fund over the last five years, for instance, delivered a 13 per cent annualised return. The Sensex delivered less than 2 per cent.

If an active fund manager beat the Sensex by 11 percentage points, would you mind paying an extra 1 per cent in fees to the manager?

The vast difference between the best and worst performing funds in India also suggests that the manager can make a big difference to returns. The worst equity fund has lost about 7 per cent a year in value over the last five years.

To top it off, passive index products in India are far from perfect. The indices themselves are narrow and concentrated.

Funds that track them have significant tracking errors which reduce returns. Advocates of low-cost investing may still offer two counterpoints.

One, equity-fund returns in India over the last five years have declined to single digits. So shouldn’t costs matter now? And two, costs may badly dent returns from a poorly performing fund.

Well, the honest response to this is that if you believe that equity funds will deliver only single-digit returns over the long term, which they did in the last five years, there is no point in investing in them at all.

Why take on equity risk if the returns are to be so measly? Costs don’t enter into the picture here.

The same logic goes for poorly performing funds, too. If an equity fund delivers only a 6 per cent return, but sports an economical expense ratio of, say, 1 per cent, why go for it at all? You invest in funds to multiply your money, not to save a few paise here and there. The only situation in which costs may matter is if you are choosing between two funds with identical track records and prospects. If faced with such a choice, go for the one with lower costs, by all means!

aarati.k@thehindu.co.in

(This article was published on July 28, 2012)
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