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Keep an eye on your direct plan’s NAV

LiveMint logoLiveMint 15-05-2014 Kayezad E. Adajania

Volatile equity markets in the past few years—apart from the last week—may have dented your equity fund returns. On top of that, mutual fund (MF) expense ratios, too, have gone up significantly. Between September 2012 and March 2014, expense ratios of diversified equity schemes have gone up by 18.40%, according to data from Value Research. Should you be worried?

Bigger spread

In September 2012, capital markets regulator Securities and Exchange Board of India (Sebi) increased the expense ratios of all schemes by about 50 basis points (bps). A basis point is a hundredth of a percent point. If schemes can get either 30% of gross new inflows, or 15% of the average assets under management (whichever is higher) from beyond the top 15 (B15) cities, they can charge additional 30 bps in the expense ratio.

By that time, Sebi had also banned fund houses from using money collected through exit loads towards sales and marketing. To compensate for this loss, Sebi allowed all schemes to collect 20 bps as exit load charge.

Put together, this pushed up the maximum expense that funds can charge a unit holder to about 3% (from 2.5% earlier).

Fund houses were happy to oblige. On average, diversified schemes’ expense ratio went up to 2.74% from 2.33% in September 2013. Hybrid debt-oriented schemes started charging about 2.40% (2.03% in September 2012).

According to Sebi rules, an equity scheme can charge at most 2.50% on the first `100 crore of its assets. For the next `300 crore, the charge comes down to 2.25%. For the next `300 crore, it’s 2.00%, and 1.75% for the rest. In simple words, as the scheme size grows, so does its expense ratio.

Of the 495 schemes analysed, the average corpus size of schemes whose expense ratio was 2.50% and above was `189 crore; and `966 crore for others.

Does it help fund houses?

Some industry participants say the extra charge has helped. “We can reach smaller cities and this benefits financial inclusion to a great extent. We get more customers from smaller towns,” said Ajit Menon, head-sales and co-head-marketing, DSP BlackRock Investment Managers Ltd.

Some fund houses, however, haven’t yet started charging extra despite getting money from such towns. “There are many complexities involved in clawing back commissions if investors withdraw before a year.

So, we haven’t yet charged these 30 bps. Fund houses are strictly audited and any mistake in such things can come back to haunt us,” said Nilesh Sathe, chief executive officer, LIC Nomura Mutual Fund Asset Management Co. Ltd. Paras Jain/Mint

Sebi rules also say that if B15 money gets redeemed within a year, fund houses must invest the additional portion of expense ratio (charged earlier) back into the scheme.

Cheaper option

In 2012, Sebi had also said that all fund houses must introduce direct plans in all their schemes. These plans should not have any distributor cost as these are meant for investors who invest directly with the fund house.

According to a Mint analysis, there is a difference of about 60 bps between the expense ratios of direct plans and regular plans of a fund house. Industry experts say that the differences vary between fund houses because of the way they account their net asset values (NAVs).

Assume that a fund’s total expense ratio is 2.25% (225 bps). Of this, a fund pays brokerage of 100 bps and another 25 bps as audit fees and other operational expenses—a total of 125 bps. The remaining 100 bps is the fund house’s income. A direct plan’s expense ratio should be less by about 100 bps (distributor fee).

Now assume that the fund house retains 150 bps as management fee and sets aside another 25 bps as audit fees. That leaves 50 bps to be given to the distributor. Now, if the fund house adds another 50 bps to the brokerage out of its own pocket, the total brokerage comes up to 100 bps.

“Expense ratios of most fund houses’ direct plans, therefore, come down by just that 50 bps. Only a few drop by the whole 100 bps,” said the head of operations of a Mumbai-based fund house who did not want to be named as he is not the official spokesperson.

Some fund houses pay a large commission to distributors, to the extent of 200 bps, and keep a lesser amount for themselves. In such cases, fund houses take a more liberal interpretation of Sebi’s regulations and deduct only the trail fees from the regular plans of MF schemes. The upfront commission still gets embedded in a direct plan’s NAV.

“In the spirit of the regulations, the difference between the direct plans and the regular plans should be the entire brokerage—upfront, trail, what is paid by the AMC and what’s charged to the scheme,” said Jimmy Patel, chief executive officer, Quantum Asset Management Co. Ltd.

What should you do?

Expenses of all schemes have gone up and these can bite a chunk out of your fund’s returns. Let’s assume that you invest a lakh each in a direct plan with expense ratio of 1.50% and a regular plan with expense ratio of 2.25%. If your equity scheme grows 15% compounded annualized in 10 years, the direct plan will yield `3.54 lakh, against `3.32 lakh in a regular plan.

The good news is that fund expenses are driven by a formula and are designed to reduce as corpus size grows. Moreover, Sebi has allowed all fund houses to charge the additional 50 bps.

The bad news is that it’s impossible to tell how much commission each fund house will deduct from its regular plan to arrive at the appropriate NAV of its direct plan. And that doesn’t bode well for direct plan investors.

You could choose schemes from Mint50, our curated list, as it takes into account expense ratios as one of the parameters, along with performance, pedigree and strategy. Also, stick with a direct plan of the scheme as it will be cheaper. Although remember, direct plans are meant only for those who have the knack to choose MF schemes on their own. If you need help, opt for regular plans.

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