How expensive is your mutual fund investment?

Historically, mutual fund investors in India belong to the ‘NAV returns’ variety. The first and last question on their minds is ‘what return has the fund given?’ Rarely, if ever, do they ask questions like ‘how much is the fund charging me? What goes into the expenses? Is it possible for the fund house to lower the expenses?’ We believe that it’s about time mutual fund investors began asking such questions; else there is a chance that they will never notice what fund houses are getting away with.

That is not to suggest that fund houses are getting away with daylight robbery. However, it pays to be aware of what the fund is charging investors. How much of the expense adds discernible value to the investment (in terms of a fund management fee), how much goes into pampering greedy mutual fund agents/distributors and banks by way of exorbitantly high commissions that add little value to the investor but add a lot of value to the distributor’s bank balance. It’s nice to be aware of these facts and then see if you still love your mutual fund investment the same way.

First it’s important to understand the structure of a mutual fund before you begin to appreciate how expenses are charged. While there are several entities involved in a mutual fund, like the Sponsors, Board of Trustees, Asset Management Company (AMC eg. HDFC Standard Life Asset Management Co. Pvt. Ltd.) and the mutual fund scheme (eg. HDFC Equity Fund), the last two are the most important elements in the context of our discussion. The AMC launches mutual fund schemes. The AMC and the mutual fund are two distinct entities. They have distinct revenue streams and expenses.

AMC’s recurring expenses

Expense	% of weekly net assets
Fund mangement fees	1.25%
Marketing/Selling Exp.	0.80%
Audit Fees	0.15%
Registrar Fees	0.12%
Trustee Fees	0.11%
Custodian Fees	0.07%
Total Recurring Exp.	2.50%

(The Recurring Expenses Table has been sourced from the Offer Document of an existing AMC)

As is evident from the table, the expenses of the AMC typically comprise of fund management expenses, marketing fees and audit fees among other expenses. Investors must note that these are expenses the fund incurs on a recurring basis (annually) to operate the mutual fund. This is over and above the entry/exit load which is a one-time fee. The entry load is usually a distribution expense that the AMC passes on to your mutual fund agent. Then there are expenses a fund incurs at the time of the NFO (New Fund Offer), which are distinct from the recurring expenses in the table above. The NFO expenses are one-time in nature, with a ceiling of 6% (of net assets), and as per SEBI (Securities and Exchange Board of India) guidelines are to be amortised over 5 years.

The recurring expenses are indicative and the actual expense could be different. Nonetheless, the AMC is not permitted to charge over 2.50% (for the first Rs 1,000 m or Rs 100 crores) to the fund. If the actual expenses exceed that figure, the AMC will have to bear the excess cost. In other words, the excess expense will shift from the mutual fund to the AMC.

There are well-defined expenses and net assets guideline formulated by SEBI. These guidelines set limits as to what the AMC can charge the fund at a particular net asset level. The below-mentioned table spells out the relationship between expenses charged and the net asset level.

Average weekly Net Assets

Net Assets	% limit
First Rs 1,000 m	2.50%
Next Rs 3,000 m	2.25%
Next Rs 3,000 m	2.00%
Over Rs 7,000 m	1.75%

As the table highlights, expenses are charged slabwise based on the net assets. For instance, an Rs 8 bn fund (Rs 800 crores), will incur expenses in 4 slabs. Likewise a Rs 6 bn will incur expenses in 3 slabs.

Having understood this, it is important to understand what is in it for the AMC. After all the mutual fund investor is happy to clock a return. The mutual fund has the AMC taking care of its expenses. What’s in it for the AMC?

There is one expense – fund management expense that is of particular relevance to the AMC. This is expense for the mutual fund, but revenue for the AMC. To put it very simply, the fund manager (along with his team of analysts) is an employee of the AMC. The AMC charges the mutual fund a fee for lending the expertise of the fund management team to the mutual fund.

We mentioned earlier that all the expenses in the ‘Recurring Expenses’ table are based on actual incidence of charge/cost. There are two exceptions to this viz. fund management charges and marketing/selling costs. Fund management expenses are charged by the AMC based on SEBI guidelines that define how much they can charge at a net asset level. These charges are not based on the actual cost (i.e. salaries of the fund management team).

Fund management expenses for equity funds

Net Assets	% limit
Upto Rs 1,000 m	1.25%
Next Rs 1,000 m and above	1.00%

Unlike custodian and registrar expenses for instance that are based on actual costs incurred by the AMC, fund management expenses are charged by the AMC based on the net asset base. These are expenses that the AMC is ‘entitled’ to charge by SEBI, irrespective of the actual expenses ‘incurred’.

The fund management expenses are very important for the AMC. It is the AMC’s only revenue stream. It is the fund management expense from which the AMC declares a profit after accounting for all expenses like salaries for its employees (which include fund managers and analysts among others), rent and administration expenses.

Equity funds can and do charge as high as 1.25% (of net assets) as fund management fee to the mutual fund. Long term debt funds are also mandated to charge a maximum of 1.25% (of net assets), but rarely do so. The reason is the returns on equity funds and debt funds are widely disparate. Equity funds give disproportionately high returns over the long term so a 1.25% fund management charge barely impacts the NAV return.

Debt funds on the other hand generate returns that are so competitive that it is nearly impossible to absorb a 1.25% fund management charge. Remember, in the books of the investor, long term debt funds are pitted against each other, as well as against comparable investments like fixed deposits and small savings scheme – National Savings Scheme (NSC), Post Office Time Deposit. So if debt funds want to attract investors’ monies, they have to trim all costs including fund management charges. Given that the total recurring expense for long term debt funds hovers in the 1.75%-2.00% range, there is very little scope to charge the entire 1.25% fund management charge to the fund. So with most debt funds, the 1.25% fund management charge is a lot lower. The percentage varies across funds, but it’s below 1.00% in most cases.

This also explains why AMCs prefer to own a larger share of equity assets than debt assets. Equity assets draw a much larger fund management fee, which has a direct impact on the AMC’s profitability. That tells investors a lot about the mad rush to launch equity NFOs (new fund offers) that has been on display for quite some time now.

Charging of marketing/selling expense is also subject to a degree of discretion. Usually, the AMC charges marketing/selling expense to the mutual fund on the basis of actual cost. Any excess over and above the 2.50% limit (for equity funds and 2.25% for long term debt funds) must be absorbed by the AMC. However, if marketing/selling expenses exceed the AMC’s initial budget, but fall within the 2.50% limit, it has the discretion to charge the excess to the mutual fund rather than take the hit on its own books. However, the AMC is more likely to take the hit for the excess marketing/selling cost on its own books, rather than charge it to the mutual fund. The reason being the competitive investment environment where a lot of investors select one mutual fund over the other based purely on NAV returns. So in a way, AMCs are constantly in a race to cut costs so they feature higher up in the NAV rankings. For reasons explained above, the race is a lot more intense when it comes to debt funds.

In the midst of this, investors should remind themselves of the initial NFO expenses that we mentioned briefly at the beginning of the article. As per existing guidelines, these expenses are to be amortised over a period of 5 years. These expenses form part of the recurring expense ceiling on equity funds (2.50%) and debt funds (2.25%). So AMCs cannot amortise the NFO expenses over and above the recurring expense limit.

As investors would have gathered, it’s a matter of choice for the AMC whether its wishes to beef up its own profitability or lower costs for the mutual fund. Since uncompromising investors have their eye on NAV returns and not on the AMC’s net profit, it seems like an easy decision for AMCs how they must allocate expenses. However, as we have seen, it’s not always that obvious. AMCs can cut the fund management charges on equity funds (from the maximum of 1.25%), but rarely do so. They prefer to do that only with debt funds because the environment demands such cost-cutting.

That is why we believe that investors must get a lot more aware and question AMCs on why they charge such high expenses when they can very well cut down on them to add to the investors’ returns. Investors in developed markets like the US for instance, have already driven AMCs into getting cost conscious and making them impose rigid ceilings on several charges, including fund management charges. It’s time for the domestic mutual fund investor to take his cue from his US counterpart.