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BW Businessworld

The Expense Ratio Fallacy

The expense ratio of a fund essentially encompasses the sum total of the costs that are incurred in distributing, managing and operating it

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In recent times, there has been a fair amount of brouhaha about expense ratios of mutual funds (MF) in India. The expense ratio of a fund essentially encompasses the sum total of the costs that are incurred in distributing, managing and operating it.

The general perception is that expense ratios for Indian MFs are inordinately high when compared to global benchmarks, leading to the rollout of a slew of ‘investor protection’ initiatives in recent years — including but not limited to banning of entry loads, capping of upfront payouts, and more recently, the mandating of stricter disclosure norms.

When one considers that the typical Indian propensity to invest in low return asset classes may be fueling an impending retirement savings crisis, this surely doesn’t bode well. MFs have consistently outperformed other asset classes in India, and yet retail participation remains dismally low at about 10 per cent of the urban population.

A 2015 study by MorningStar actually seems to corroborate the fact that Indian MFs are indeed more expensive when compared to their foreign peers. However, an in-depth perusal of this study conducted by FIFA (Foundation of Independent Financial Advisors) effectively quashes this notion.

According to the FIFA report, comparing expense ratios of bundled and unbundled funds is akin to making an ‘apples to oranges’ comparison, as this approach doesn’t accurately capture the total “cost of ownership” being borne by an investor. In unbundled funds, an advisor is compensated directly by the investor; this complicates expense ratio calculations greatly.

In India, money market and fixed income funds (which make up nearly two-thirds of the total industry assets) have a category weighted average cost of just 0.40 per cent. For equity oriented funds, the FIFA study came up with an average expense ratio calculation of 2.14 per cent (1.87 per cent before service taxes), which differed markedly from MorningStar’s calculation of 2.65 per cent. According to the report, MorningStar is yet to respond to their queries related to this seemingly large discrepancy.

Many types of fees and charges (such as front end loads and performance linked fees) that are permitted in other countries are disallowed in India. Front end loads traditionally range from 0 to 5 per cent globally; in some countries, these loads are negotiable. SEBI banned entry loads in India in 2009.

FIFA’s report indicates that when the actual total cost of ownership in case of equity funds is considered, India ranks as the fifth least expensive country out of 25 countries reviewed in the MorningStar Report. That hardly seems to justify the regulator pulling out the stops. Perhaps a closer look at the actual cost of ownership visa a vis global benchmarks is warranted at this stage.