Insights

Impact of proposed expense ratio hike

July 21, 2012 . Srikanth Meenakshi

A tweet from Subramoney (a.k.a P V Subramanyam) prompted this post. Commenting on the rumored recommendation waiting for SEBI clearance about hiking expense ratio of mutual funds and passing on service tax to investors, he wrote:

a 2% load is less hurting than a 2.90% amc charge. Will somebody tell this to Sebi please?

Well, the proposal to increase expense ratio would put the maximum limit on the chargeable percentage at 2.81% (2.25% + 25% + (12.36% of 2.5%) = 2.809%). However, the more important thing is how much it would erode investment returns and whether, really, a 2% load is a better option. I opened a spreadsheet and did some math.

Turns out, Subra is right after all 🙂 For any holding period beyond 3 years, an entry load is better for investors than the proposed expense ratio hike. You can see the numbers for yourself below in a table. I also threw in the existing status quo, and a fully free (no load, 0% expense ratio) scenario as well for good measure.

Initial investment 10000
Growth per year (assumption) 10%
Assumed expense ratio 2.25% 2.81% 2.25% 0.00%
Investment post load 9800 10000 10000 10000
With 2% load and 2.25% expense ratio With 0% load and 2.81% expense ratio With 0% load and 2.25% expense ratio With 0% load and 0% expense ratio
1 year  10,537.45  10,690.90  10,752.50  11,000.00
2 years  11,330.39  11,429.53  11,561.63  12,100.00
3 years  12,183.01  12,219.20  12,431.64  13,310.00
4 years  13,099.78  13,063.43  13,367.12  14,641.00
5 years  14,085.53  13,965.98  14,372.99  16,105.10
6 years  15,145.47  14,930.89  15,454.56  17,715.61
7 years  16,285.17  15,962.46  16,617.52  19,487.17
8 years  17,510.63  17,065.31  17,867.99  21,435.89
9 years  18,828.30  18,244.35  19,212.55  23,579.48
10 years  20,245.13  19,504.85  20,658.30  25,937.42
Gross returns 102.45% 95.05% 106.58% 159.37%
Annualized returns 7.31% 6.91% 7.53% 10.00%

And, here is a graph:

 

The increase in expense ratio is aimed at bolstering the fundamentals of the mutual fund industry and its business. Will that translate to enhanced returns which will make the investors grin and bear the increase in the expense ratio? Only time will tell…

Edit: There is a different interpretation of the proposed expense ratio hike which says that the service tax will apply only to 1% of the expense ratio (not sure how this would work in the presence of fungibility, but nevertheless). In that case, the TER would work out to be 2.62%. The ten-year CAGR would come to 7.11% and the investment would do better than the 2% load scenario until the sixth year of investment. You can see the alternate graph here.

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3 thoughts on “Impact of proposed expense ratio hike

  1. you have simplified life for a lot of FINANCIAL (!) JOURNALISTS (!!)…now imagine a 30 year sip (frankly it does not matter whether my money remains in one house or multiple houses, as long as it stays in a mf, this works)…see the impact.

    It is HUGE. Innumeracy helps. Everybody happy. Journo can do a story “Sebi did not succumb to industry pressure: says NO to entry load”.

    Expecting to see 3-5 IPOs of MFs. Investor be ……. (u can fill in any word). Not sure how good is your Hindi. In North the ‘common man’ is called ‘aam aadmi’ – to me it translates to ‘Manga Madayan’ – ‘aam’ is of course the Hindi word for mango!!

  2. Theoretically you & subra are right, but

    A. Giving a 2% load is asking for trouble what you will end up with is 4.25% (2% load every year 🙂 cost vs 40bps higher as being discussed now.

    B. Assuming the increased TER comes through as you have calculated it would mean nett 60+bps increase which is significant assuming a 10% growth ( sort of Index like let us say). So between this and status quo ( throwing the Swarupish all returns no cost theory out )

    Instead of assuming future data let us look at past data,

    Last 10 yr nifty return is 17.50% which is pretty high and real. to put it in perspective the average of large cap funds (including index funds) gave 19.14% or 1.6% alpha, If only the managed funds were taken into account another 50-100bps can be added safely i presume to the average return.

    Franklin India Bluechip is the best of the lot with 25% return over the same period. Even a ho-hum L&T Growth is 20% a full 2.5% higher than Nifty.

    So depending on whether you invested in Index, got the average fund return, best fund return or a ok fund return your real return would have increased by nil,15%,85% or 23% higher.

    What im trying to say is that the alpha is significant, and it is post expense to boot.

    Coming back to the assumption if we get the same 1.6% alpha on an average over index return for next 10 years, it will offset the increase in expense.

    I know that the status quo is the best but we have no choice but to experiment to increase inflows.

    So its either 2.81 or 4.25%. Now the choice looks fairly obvious 🙂

    So are we missing the wood for the trees? when millions of investors can get significantly higher inflation adjusted, tax free returns all we can debate is 0.4 and 0.6% ? that is the question to ask IMO.

  3. The expense ratios of most mutual funds is already exorbitant. Most funds charge 2% to 2.5%. If one compares this with some of best mutual funds in the world, it is shocking that funds with SEBI support can charge such high fees. Most funds in US have expense ratios in the range of 0.5% to 1.5%. If one invests in US ETFs, the expense ratio is even less ( 0.1% to 0.7%)
    SEBI should ensure that fund charges are kept to min. This will result in more investors and investments.
    Needless to say, most funds barely beat the comparative Index and with all the management and fees, one cannot be confident that their investment in the fund is ‘safe’.

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