Regulatory Impact. How you can gain from lower expense ratio

In a bid to reduce mis-selling and cut costs for mutual-fund investors, SEBI brought in various regulatory changes last week.

Lowering the cap on total expense ratio for various funds and banning upfront commission are among the key changes that will make investing in mutual funds cheaper for you. The impact will be greater on equity schemes with a larger corpus of over ₹10,000 crore, as the cap on expense ratio has been brought down by 25-70 basis points for large funds.

Why expense ratio matters

Mutual funds charge investors for managing their schemes. This charge is called the total expense ratio (TER). Recurring expenses such as management fee, distributor commission, registrar fee, trustee fee and marketing expenses total to TER, which is expressed as a percentage of the assets managed. Fund houses declare the net asset values (NAVs) of schemes after taking these expenses into account.

Hence, a notable change in TER can significantly impact your final corpus in mutual funds. For instance, if you invest ₹1 lakh in an equity mutual fund with a portfolio return of 12 per cent and expense ratio of 1.75 per cent, your corpus after 15 years will be around ₹4.32 lakh.

If this expense ratio is lowered to 1.4 per cent, your corpus straightaway increases by ₹20,000. This is why SEBI’s review of TER, which can lower expense ratio by 35-45 bps for many large-sized schemes, is good news for you.

What’s changed

The maximum TER a fund can charge its investors is prescribed by market regulator SEBI. Earlier, equity-oriented funds were allowed to charge a TER of 2.5 per cent. SEBI further set sub-limits for TER based on the size of the assets managed. Earlier, for equity schemes, fund houses could charge 2.5 per cent for the first ₹100 crore, 2.25 per cent for the next ₹300 crore, 2 per cent on the next ₹300 crore and 1.75 per cent for the balance (beyond ₹700 crore).

As per SEBI’s latest revised norms, the maximum TER funds can charge is 2.25 per cent in the case of equity-oriented schemes having an asset under management (AUM) of up to ₹500 crore (see table).

TER reduces as the scheme AUM increases. It has been brought down to 1.05 per cent for equity AUMs of over ₹50,000 crore. While no fund house currently has any equity scheme in the over-₹50,000-crore category, many have assets in the ₹10,000-30,000-crore category that can see a sharp 35-45 bps reduction in expense ratio.

For debt schemes, the limits on expense ratio have also moved lower — 25 basis points less than the corresponding rates for equity funds in each slab. This, too, will have a sizeable impact on returns. Since returns on liquid, arbitrage and other short-term debt funds are in the 6-9 per cent range, even a small reduction in TER will significantly bump up returns.

Given that index funds have very little scope to add spunk to returns, TER changes matter even more. Expense ratio for index funds was earlier capped at 1.5 per cent. It has now been brought down to 1 per cent. Since most index funds already have expense ratio below the prescribed limit, SEBI’s move will not have any impact.

Funds to keep a watch on

A point to remember is that while SEBI has been prescribing the maximum cap on expenses, many funds have been sporting an expense ratio over and above the prescribed limit. How?

This is because funds get to charge an additional 30 basis points if the inflows come from beyond the top 30 cities (permissible only for inflows from individual investors, as per SEBI’s new guidelines), and another 5 basis points in lieu of exit load and the GST component.

Hence, while SEBI has sharply lowered the limits on the expense ratio for large-sized funds, the funds may charge 30-35 bps more than the new permissible limit. That said, since many funds already have expense ratios above the prescribed limits, owing to other components, a sharp reduction in the expense ratio of funds with assets more than ₹10,000 crore is imminent.

HDFC Equity, HDFC Mid-Cap Opportunities, Kotak Standard Multicap, Aditya Birla SL Frontline Equity and SBI Bluechip are funds with assets of over ₹20,000 crore as of August 2018, with an expense ratio of 2-2.3 per cent currently.

These funds could see 35-40 bps reduction in expense ratio as per the new structure.

ICICI Pru Bluechip, Axis Long Term Equity, ICICI Pru Value Discovery, HDFC Top 100, Motilal Oswal Multicap 35, Franklin India Equity, Reliance Large Cap, Reliance Tax Saver, Aditya Birla SL Equity and Reliance Multi Cap have assets of over ₹10,000 crore. These funds have an expense ratio of 2-2.3 per cent. SEBI’s move offers leeway for 30-35 bps reduction in their expense ratios.

In the debt-fund category, most large-sized funds already have expense ratio less than the newly prescribed limits. However, HDFC Credit Risk, Aditya Birla SL Medium Term, ICICI Pru Credit Risk, Franklin India Short Term Income and Reliance Credit Risk are funds that have a corpus of over ₹10,000 crore and carry 1.6-1.8 per cent expense ratio currently.

Here, there is a scope for reduction of 40-60 bps in expense ratio, which can make a significant impact on the returns of these funds that currently deliver 7-9 per cent over a long period.

In a bid to reduce mis-selling in close-ended schemes, SEBI has set TER at 1.25 per cent for equity and 1 per cent for debt schemes. Many schemes in the debt category have been charging more than 1 per cent, and even 2 per cent in some cases.

Expense ratio for close-ended equity schemes have been in the 2.5-3 per cent range. There could be a sharp reduction in expense ratios in these funds, too.

Other changes

SEBI has banned upfront commission and mandated that all commission and expenses are to be paid from the scheme alone and not from the AMC/associate/sponsor/trustee. This can also help bring down costs. All in all, the regulatory changes have brought good tidings for MF investors.

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