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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