Here's why you should care about your mutual fund fees

Nazim Khanmoneycontrol.comLast week, investment legend Warren Buffett yet again took aim at the fee structures of hedge funds, saying “they eat up capital like crazy” and that, for investors on average, the net result of hiring professional management was “a huge minus”.

Buffett’s stand on fees charged by hedge funds, usually revolving around the “2 and 20 (2 percent of assets, by way of management fee and 20 percent share in profits, if any)” is not new.

In 2008, he famously entered into a USD 1 million bet with a hedge fund manager, saying that a low-cost S&P 500 index fund would beat the returns of hedge funds selected by the latter over a 10-year period. (Proceeds of the bet would go to charity.) As of last month, Buffett’s selection is winning handsomely: 65.7 percent absolute returns for the S&P 500 versus 21.9 percent for hedge funds.

But if high hedge fund fees are an impediment in the way of good returns, how are Indian investment vehicles faring?

Mutual funds have served as a solid instrument for retail investments into the share market. But handing over your money to a professional to manage comes at a cost. Called expense ratios, fund companies deduct fees from an investor’s corpus annually, as a charge for providing the asset management service.

However, some, such as Dhirendra Kumar, Founder and CEO of investment research firm Value Research, believe that the current management fees charged by fund companies -- an average of about 2.25 percent for the typical equity scheme -- are too high.

“The current cost structure in the Indian mutual fund business is not justified,” he says. “There was a case for higher fees when companies assets under management (AUM) was small. But they enjoy the benefits of economies of scale.”Kumar’s argument about scale makes sense: a team comprising of a fund manager and a few research analysts can about as well manage a fund of Rs 100 crore corpus, as they can of Rs 1000 crore.So as the industry’s assets under management grow – they stood at Rs 13.5 lakh crore during the March quarter – costs should come down.And over the long term, costs add up. A Rs 5,000 per month SIP in a fund costing 2.25 percent over a period of 25 years incurs management cost of Rs 18.4 lakh, according to a mutual fund fee calculator. The same investment in a fund costing 1.25 percent would incur Rs 10.16 lakh. The impact of compounding means investments in a lower-cost fund would add up to even more.Kumar says that Sebi should intervene and look to bring down mutual fund costs, something that a recent DNA report claimed the regulator is likely to do soon.Currently, equity funds are allowed to charge a maximum of 2.5 percent expense ratios for the Rs 100 crore assets, 2.25 percent for the next Rs 300 crore and 1.75 percent beyond that. Separately, they can charge an additional cumulative 50 basis points for exit fees and for selling funds to investors beyond the top 15 cities.It must be remembered than in a move that caused much heartburn for fund companies, the regulator had in 2009 banned "entry loads", fees that an investor would pay upfront while making an investment, which asset managers would typically pay to financial advisors.Investors also have the option of considering investing in index funds or ETFs (the latter are charged at brokerage rates), which being passive investment vehicles typically cost lower. Passive instruments try to emulate the returns of an underlying index rather than try to beat them.But Kaustubh Belapurkar, Director of Manager Research at Morningstar India, says they may not be the best alternatives to a costlier actively managed fund.“The average active largecap fund has outperformed its benchmark by about 250-500 basis points (2.5-5 percent) over the long term,” he says. “Midcap funds have done even better.”This indicates that even as managers are charging a premium for providing fund management services, they are earning their keep. In contrast, in the US, the average fund, which costs less than 1 percent according to a 2015 Morningstar study, has failed to beat the market.In any case, Belapurkar says that a direct comparison of fund expense ratios in India and the US cannot be undertaken. In the case of the latter, fees are exclusive of those paid to financial advisors. “The average investor in a developed market pays about 75 basis points to the financial advisor. In India, fund companies pay this out of their own pockets,” he says.What is the average investor then to do? Do not gloss over a good quality active fund only because its fees are high but consider switching to an equally-good lower cost alternative, if available.