SLATE. All you wanted to know about expense ratio

Last week, SEBI chairman UK Sinha reprimanded Indian mutual funds for their excessive charges. Among his peeves was the high commission paid by some mutual fund houses to distributors. Now, mutual funds the world over charge many types of costs to investors — entry and exit loads, management fees and transaction charges. In India, entry loads are banned by SEBI (exit loads are allowed, though). While you are free to pay an extra advisory fee or brokerage to your distributor, all other costs that a fund may charge are packed into the metric called ‘expense ratio’.

Expense ratio is the cost of running and managing a mutual fund which is charged to the investor. It includes fund management fees, marketing or selling expenses, transaction costs, investor communication costs, custodian fees, and registrar fees. The expense ratio is calculated as a percentage of the fund’s average net asset value (NAV). The daily NAV that a fund puts out in the public domain is after deducting the expense ratio.

But mutual funds are not allowed to charge whatever they please as expense ratio. The ratio is subject to SEBI-imposed limits. So, for actively managed equity funds, the expense ratio allowed by SEBI is a maximum 2.5 per cent for the first ₹100 crore (average weekly net assets), 2.25 per cent for next ₹300 crore, 2 per cent for the subsequent ₹300 crore and 1.75 per cent for the balance corpus. For debt funds, the expense ratio allowed is 0.25 percentage points lower than equity funds.

Within these limits, the expenses are fungible. That is, funds may allocate costs as they like between their fees and other expenses.

Besides this, to widen reach, mutual funds have been allowed to charge up to 30 bps more if 30 per cent or more of their new inflows come from locations beyond the top 15 (T15) cities. A proportionate charge is allowed if the new inflows from the B15 (beyond top 15) locations is less than 30 per cent. Service tax on fund management charges is also passed on to investors, which adds to the expense ratio.

Globally mutual fund costs are under intense scrutiny from investors, who have been migrating en masse to index funds and exchange traded funds. But expense ratios of mutual funds in India seem to be on the rise. Some equity mutual funds now charge close to 3 per cent from 2 per cent two years ago. Now this may be within SEBI-mandated rules. But the regulator is frowning because a higher expense ratio eats into investor returns and also because it runs counter to the global trend. If mutual funds rein in distributor commissions, the expense ratio may decline.

Shelling out 3 per cent towards fund expenses may not seem like much when equity funds are delivering a 30-40 per cent return for the year. But when long-term returns normalise to 14-15 per cent, paying out 3 per cent a year can hurt. Ditto for debt funds where even double-digit returns occur once in a blue moon.

Still, while expense ratio is important, it should not be the only criterion while selecting funds. A fund with a solid track record but a higher expense ratio may be better than one which charges less but gives poor returns. Similarly, the direct plans of mutual funds may make sense only if you have the expertise to select good funds. A poor choice may save pennies but cost pounds.

If the SEBI chief is worrying about fund costs, its time you did too.

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