MF Analysis - Impact of high expense ratio on returns

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  • 1. 1Mutual Fund Analysis July 27, 2011Impact of Expense Ratio on Returns:Prologue: The performance of mutual fund schemes is invariably affected by costs that are charged by the mutualfund companies for their services. The impact of such costs on returns is considerably larger for the investmentsthat are kept over long term. These charges called as expense ratio, deducted from the net assets, impair thereturns of the mutual funds schemes.What is an Expense Ratio? Expense Ratio is a total annual cost charged by mutual fund companies to manageinvestors’ money. Expense ratio, expressed in percentage form, is calculated by dividing the operating expenses bythe average daily or weekly net assets. It is calculated or estimated on an annual basis and deducted from the netassets on a daily basis. That means, the NAV of a scheme is declared on a daily basis after deducting the expenses.The asset management company which manages the fund, the custodian who is responsible for maintaining thefunds and securities, the R&T agent who maintains the investor records, distributors who bring the investors to thefund, the trustees, the auditors, all charge a fee for their services. All these expenses constitute expense ratio andis deducted from the net assets / corpus of the fund. For example, if a pool of Rs.100 crore is invested and is worthRs.120 crore after a year. The return is 20%, but this is before charging costs. If the fund charges a cost of 1% on theportfolio, the value of the portfolio would be Rs.119 crore and the return would be 19%.Expense ratio measures the total cost of investing in a fund for an investor. Generally, a fund with lower expenseratio is considered more attractive than the one with higher expense ratio.Components of Expenses: The components of such operating expenses usually consist annual Management Charge(charged by the fund manager for managing the fund), Trustee, Audit and Legal Fees, Administration andOperational Fee – (Such as cost for premise / establishment, customer servicing, delivery of statement, marketing& selling and other process charges) and transaction Fees (cost incurred in buying or selling underlying assets forrebalancing / subscription / redemption purpose).Impact of Expense Ratio on MF Returns Retail Research
  • 2. 2Mutual Fund Analysis contd…Impact on schemes returns: Performance of mutual fund schemes is affected by expense ratio since it isdeducted from the net assets.To illustrate how much the expense ratio can impact the returns, we considered three schemes which are assumedto have grown in the same compounded rate of 10% per annum for next 25 years. Rs. 1,00,000 each is invested inthe Schemes –A, B and C with varying expense ratio of 1.00%, 1.50% and 2.00% respectively. Apparently, the finalreturns from these schemes will turn out to be widely different depending on their expense ratios. The growth ofthe investment at the compound rate of 10% for 25 years without any deduction would have reached to Rs.10,83,471.In the case of Scheme C having 2% as expense ratio, would have grown to Rs. 6,84,848 or 37% lower than a noexpense fund due to the higher expense ratio of 2%. On the other hand, the corpuses of fund ‘A’ and ‘B’ wouldhave reduced by 20% and 29% respectively at the end of 25 years since their expense ratios were at 1% and 1.5%respectively.High Expense Ratio impairs the performance of Mutual Funds:1,200,0001,000,000 800,000 600,000 400,000 200,000 0 1 4 7 10 13 16 19 22 25 Grow th at the rate of 10% CAGR Fund A (1%) Fund B (1.5%) Fund C (2%)Impact of Expense Ratio on MF Returns Retail Research
  • 3. 3Mutual Fund Analysis contd…Comparison of reduction on returns with different expense ratios: CAGR growth of Rs. 1,00,000 over 25 years.Impact of Expense Ratio on MF Returns Retail Research
  • 4. 4Mutual Fund Analysis contd…The above table shows that the difference in the returns is higher in long term holding compared to short termholding. In a nut shell, mutual fund schemes with lower expense ratio would provide better returns over the longrun compared to schemes with higher expense ratio.Impact of Expense ratio on different categories of Mutual fund schemes:On Equity oriented schemes: The impact of expense ratio on equity oriented schemes is lower than that in thecase of debt funds as the return expected from the schemes is significantly higher than expense ratio. As equityfunds are more volatile than other mutual fund categories like debt, they require extra effort to be managed andthey are allowed to charge marginally more than what debt funds can charge.Distribution of Expense Ratios of Equity Diversified Category – 250 schemes: 160 135 120 80 47 40 34 3 2 0 1.50 to 1.75 1.75 to 2.00 2.00 to 2.25 2.25 to 2.50 Above 2.50 Total of Corpus (RS Crs) 177 90,424 20,208 23,007 330 It is observed that the schemes with expense ratio between 1.75% and 2.25% are mostly top rated and yield better than average returns.Impact of Expense Ratio on MF Returns Retail Research
  • 5. 5Mutual Fund Analysis contd…On Equity Index schemes: The performance of index fund is dependent on the expense ratio and tracking error.Tracking error indicates how closely the index fund return matches with of the underlying tracked index. The indexfunds are passive funds requiring less effort to manage them. Lower expense ratio and lower tracking error willmake sure that the index fund performance matches the underlying index performance.On Debt schemes: In debt mutual fund, expense ratio is an important parameter to consider. The gross return fromdebt mutual funds are in the range of 5% to 8%, so expense ratio of 0.5% to 1% will have significant impact on thenet return of the debt fund. In case of liquid and ultra short term schemes, the returns are even lesser and evensmall differences in the expense ratio of schemes can make significant impact on their net returns.It is to be noted that there is an inverse relationship between the expenses and the value of corpus, whenever thecorpus is affected by not flows but change in values. Whenever the yields of debt instruments fall, the bond pricesrise and along with the value of corpus of the schemes. At such times, though the expenses remain largely fixed,the denominator (I.e. the corpus) rises, leading to a fall in the expense ratio. Conversely in times of falling values,expense ratio could rise. The chart below portrays the fluctuation in the expense ratios of Income and Gilt Medium& LT category in relation with the 10 Year benchmark yield over the last five years.Inverse relationship between Expense ratio and 10 Yr G sec Benchmark Yield:1.60 Income Funds Gilt Funds - Medium & LT 10 Yr Yield 9.001.50 8.50 8.001.40 7.501.30 7.001.20 6.501.10 6.001.00 5.50 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10Impact of Expense Ratio on MF Returns Retail Research
  • 6. 6Mutual Fund Analysis contd…Trend in Expense Ratio in MF Categories over periods:2.35 Period betw een March 2005 to m arch 20111.851.350.850.35-0.15 Liquid Funds Ultra Short Term ST Income Funds Income Funds Equity DiversifiedSEBI’s regulation on Expense ratio against the corpus: SEBI’s Mutual Fund Regulations specify the maximum limitof the expenses that can be recovered from the investors every year. For equity schemes the maximum limit thatcan be assigned is 2.50% of the assets of the fund while for debt funds the limit is 2.25%. This is 1.50% in case ofpassively managed funds such as index and ETFs.Depending on the type of scheme and the net assets, operatingexpenses are determined by limits mandated by the SEBI Mutual Fund Regulations, which are as follows:The above table shows that the expenses of the scheme decreases if the corpus increases. So, investors have toconsider the size of the funds while making investment decisions.SEBI specifies only those expenses that can be directly related to a scheme, such as investment management fee,custodian, R&T agent and other constituents, can be charged to investors. The investment management fee is apart of these total costs, and cannot exceed 1.25%.Impact of Expense Ratio on MF Returns Retail Research
  • 7. 7Mutual Fund Analysis contd…Category wise Highest and Lowest Expense Ratio schemes from top 10 schemes in terms of corpus:Equity Diversified – Large Cap: Note: The returns given in the tables below are absolute up to 1 year and above one year are CAGR. NAV values are as on July 26, 2011.Equity Diversified – Mid & Small Cap:Equity Diversified – Multi Cap:Impact of Expense Ratio on MF Returns Retail Research
  • 8. 8Mutual Fund Analysis contd…Hybrid - Equity Oriented:Gilt – Medium and LT:Income Funds:Liquid Funds:Impact of Expense Ratio on MF Returns Retail Research
  • 9. 9 Mutual Fund Analysis contd… Ultra Short Term Funds: Short Term Funds: Conclusion: It is to be noted that schemes with lower expense ratios are not necessarily better than the schemes with higher expense ratios. It can be one of the parameters amongst many others to choose a scheme to invest. If the returns delivered by a scheme are consistently commendable, investors need not to pay more attention to expense ratio even if they are high as he is concerned with the net return to himself. Expense ratios can be useful in choosing between funds of comparable track record, size and investment strategy. The difference in expense ratio could compound into a sizeable difference in returns over long run. Analyst: Dhuraivel Gunasekaran.RETAIL RESEARCH Fax: (022) 3075 3435Corporate Office: HDFC Securities Limited, I Think Techno Campus, Building –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station, Opp. Crompton Greaves,Kanjurmarg (East), Mumbai 400 042 Fax: (022) 30753435 Website: www.hdfcsec.comDisclaimer: Mutual Fund investments are subject to risk. Past performance is no guarantee for future performance. This document has been prepared by HDFCSecurities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or made available to others. Itshould not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed reliable.We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time to time positions or options on, and buyand sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or other services for, any company mentioned in thisdocument. This report is intended for Retail Clients only and not for any other category of clients, including, but not limited to, Institutional Clients. Impact of Expense Ratio on MF Returns Retail Research