Mutual Funds: The Expense Ratio Trick

I regularly write against mixing investments and insurance. I highlight issues in the cost structures of various investment and insurance combo products. Regular readers would know that I like mutual funds for investments. However, I must concede that the mutual fund companies do not really smell of roses. I have written about many issues with their intent and communication to the investors.

In this post, I will highlight a recent experience where I think the AMC is taking investors for a ride (I may be wrong here). 

A client got this e-mail from Aditya Birla Sun Life mutual fund:

In compliance with provisions of SEBI Circular No. SEBI/HO/IMD/DF2/CIR/P/2018/18 dated February 05, 2018 on change and Disclosure of Total Expense Ratio (TER), please note that the base Total expense ratio of Aditya Birla Sun Life Savings Fund – Direct will be revised from 0.20% to 0.60% effective 13-Sep-19.

Aditya Birla Savings Fund is an ultra-short duration debt mutual fund. 0.2% to 0.6%. That is a 200% increase. I see minor increases (or decreases) in expense ratios all the time. However, a 200% increase is too much.

What would warrant a 200% increase in a debt mutual fund?

Remember this is a direct plan. The increase in the expense ratio of direct plans flows directly into AMCs’ pockets. There is no distributor involved in direct plans. By the way, the expense ratio of the regular plan was also increased by 0.4% from 0.32% to 0.72%. However, since the difference between expense ratios has not increased, nothing extra flows to the distributor.

How high is high?

Now, SEBI regulations allow charging a much higher expense ratio (Board meeting on September 18, 2018).

However, there is competition and a higher expense ratio eats directly into your returns. Therefore, the AMCs can’t keep charging the maximum amount.

Back to the question, how high is a high expense ratio?

A good way to examine this is to compare the expense ratios in the peer category (Ultra Short Duration Funds). I compared the expense ratio of various ultra-short duration funds (direct plans) on ValueResearch. Do note expense ratios change quite frequently and hence the data on expense ratio may not be updated. Here are the top 5 in terms of expense ratio.

As you can see, the highest is 0.42.

I understand 0.42% can’t be the benchmark. However, 0.60% is almost 50% more than the previous highest. Not just that, 0.42 is the Total TER.  0.60% is the Base TER. Total TER will be slightly higher. However, let’s stick with Base TER for now.

We must also note that Aditya Birla Savings Fund is a Rs 15,421 crore fund (as on August 31, 2019). Increase in expense ratio from 0.20% to 0.60% in a direct plan of a Rs 15,000 crore mutual fund scheme means an additional Rs 60 crores per annum in the AMC’s kitty. 0.2% is Rs 30 crores per annum. 0.6% is Rs 90 crores. And it is your Rs 60 crores that will be transferred to the AMC over the year (if the expense ratio remains this high). Moreover, the fund size will grow with returns and further inflows.

In my post on how to select debt mutual funds, I had pointed out expense ratio as one of the important parameters while selecting debt funds. Lower the expense ratio, the better it is for you. A 0.4% increase in expense ratio knocks off 0.4% p.a. from your future returns. In the case of debt funds, the upside is limited, and it is easy to understand the source of risk and excess return. I am not comfortable with debt funds that have a higher expense ratio and high returns. Such funds may be taking extra risk. 

I do not know if the other AMCs have done this.

Why would the Aditya Birla Sun Life do this?

Well, because it wants to make more money.

It is possible that a lot of money in this fund is retail money. Retail money is relatively sticky and won’t flow out so soon. With debt funds, there are tax implications on quick exits too. If this is indeed the case, then increasing the expense ratio of the direct plan is a quick way to shore up profits. By the way, I don’t know if that is really the case or where I can check the breakup of funds in a fund scheme.  This is just a conjecture (or an allegation). At the same time, I don’t think corporate treasuries or institutional investors will put up with this kind of nonsense.

Moreover, the expense ratio for only this scheme has increased so sharply. Expenses for the other big debt schemes such as ABSL Liquid Fund, Corporate Bond Fund or Money Manager schemes have not been increased. Why should only the investors of ABSL Savings Fund suffer?

It is possible that this is only temporary and there is a very plausible reason behind this.  It is possible that the expense ratio will go down soon. By the way, investors are losing Rs. 5 crores every month.

I do not know how arbitrary the calculation of expense ratio can be. I have written to the ABLS mutual fund seeking their response. I have not received any response yet. I structure my clients’ portfolios primarily using mutual funds. Therefore, I will be the happiest if the AMC provides a convincing answer and assures that the investors are not being short-changed.

As per SEBI circular (Total Expense Ratio: Change and Disclosure) dated February 5, 2018, any change in the base TER in comparison to previous base TER charged to the scheme shall be intimated to the Board of Directors of AMC along with the rationale recorded in writing. The changes in TER shall also be placed before the Trustees on quarterly basis along with rationale for such changes.

I don’t see why the rationale for such a sharp hike cannot be shared with the investors.

From an investor point of view, such a sharp increase in expense ratio is also a breach of trust. You could have invested in this fund based on its low expense ratio or its size or its portfolio quality. Perhaps, your biggest reason for investing in this fund has been quietly taken away.

This could also be money-making playbook. Push a debt fund scheme aggressively to the retail investors. Bigger investors and HNIs can be diverted towards other schemes. Once the scheme is big enough, increase expense ratios sharply.

Update: ABSL team got in touch with me but did not offer a convincing answer. They did mention that this hike was temporary and will soon revert to lower levels in a few weeks. It does not look good. MF Expense ratios can’t be subject to whims and fancies of AMC management. Even a month of higher expense means a loss of Rs 5 crores to the investors.

Low Direct plan expense ratio and High commissions

My other observation pertains to Mirae Asset. Mirae Asset has been in asset gathering mode of late. They have changed the classification (and commentary) of their equity funds often and have launched a few equity funds in the recent past. For some of their new funds, the difference between the expense ratios of direct and regular plans is very high. It is a fine business strategy, especially for smaller fund houses like Mirae. To attract more funds, they must incentive the distribution chain.

Now that the difference between regular and direct goes to the intermediaries and there are caps on total expense ratio, Mirae has kept the expense ratios of direct plans really low for the investors (so that they can pay a higher commission to the distributors).

You can see that the difference in expense ratio for the two most popular plans (Emerging BlueChip and Large Cap Funds) is about 1%. It is about 1.7% for the Mirae Asset Hybrid and Mirae Tax Saver Fund.

Very good for direct plan investors. Not so much for the regular plan investors. You can see that the difference in 1-year returns in Hybrid equity and Tax Saver fund is also ~ 1.70%. The Mirae equity funds have done well and the returns to the regular plan investors have been good too (even better than direct plans of peer schemes). However, if this trend continues and if the regular plan investors compare their returns with direct plan investors, it would hurt. The regular plan investors would notice the difference when the scheme performs badly.

You can see that the difference in 3-year returns for Mirae Hybrid Equity is almost 2% p.a. Rs 1 lac invested 3 years back in the regular plan would have grown to 1.28 lacs. With the direct plan, the money would have grown to 1.35 lacs (5% higher). And this is just over 3 years. If we extrapolate this difference to 10 years, the difference would be Rs 45,000 (19% higher). In 20 years, your direct plan corpus would be 42% higher than the regular plan corpus.

At the same time, as the fund sizes grow, I would expect the expense ratio of the direct plans to rise and the difference between the regular and direct plan expense ratio (and returns) to fall in the range of the flagship funds.

Do note this is not a negative observation about Mirae Asset.  It is not doing anything wrong. with respect to expense ratios. To an extent, it is also inappropriate to club this example with Aditya Birla Sun Life Savings Fund, where things look really bad. In a way, it is taking a hit by keeping direct plan ratios low and passing on the benefit to distributors. It is more about the impact on return for regular plan investors. They are losing way too much in the form of commissions.

Simple Lesson: Invest in Direct plans, especially if you have a big portfolio.

Disclosure

Some of my clients have investments in Aditya Birla Sun Life Savings Fund. Being a SEBI Registered Investment Adviser, I may have vested interested in discouraging investors from investing in regular plans of mutual fund schemes.