Why costly funds can deliver more

Why opt for costly funds?

A study of funds with a higher expense ratio reveals that some of these funds’ returns over a three and five-year period are among the best.

The expense ratio charged by mutual funds is once again under the spotlight. The market regulator, SEBI, is considering lowering the ceiling for the total expense ratio (TER) from the current 2.5% for equity funds. The TER for many schemes is as high as 300 basis points or 3% of the assets under management (AUM). One way to avoid paying such a high cost is to opt for the direct plan of the scheme, which comes with a much lower expense ratio as it does away with intermediary costs. But, if you are not comfortable investing on your own, paying a higher TER for the regular plan is your only option. Does it mean investors in mutual funds’ regular plans, to lower their costs, need to avoid funds with a higher TER?

Let’s first understand the concept of TER. It refers to a percentage of a scheme’s corpus that a fund house charges towards administrative, fund management, and other expenses. This is charged to the overall assets of the scheme and is a recurring expense. A fund’s net asset value is arrived at after deducting this expense on a daily basis. Thus, a higher expense ratio eats into the fund’s actual returns. The return that your fund shows in your statement is after deducting this expense. Over the long term, these expenses add up and whittle away your corpus. But, these expenses need to be seen in the context of the performance delivered by the fund. With this in mind, we looked at the three and five-year performance figures for all diversified equity schemes with a TER in excess of 2.5% and a track record of at least three years.
Costly funds performance 2016

 

There are 70 equity schemes that fall in this bucket of `expensive’ schemes. Data from an investment research company shows that almost half (33) of these schemes have beaten their category average over the past three years. The five year performance analysis paints a similar picture: 29 out of the 62 funds with an expense ratio higher than 2.5% have outperformed their respective category average during this period.

The relatively smaller corpus size of these schemes keeps their expense ratio on the higher side, but there are some stand-out performers among them. Motilal Oswal MOSt Focused 25 Fund, with a TER of 3.15% (as on 30 April) is among the most expensive schemes across categories. Despite the steep cost, it has built a stellar track record in just over three years of operations. The fund is placed in the top quartile of performers during this period. Tata Ethical Fund, a multi-cap offering, is another expensive fund with a TER of 3.05%, but is among the consistent out-performers in its category. In the mid-cap space, Birla Sun Life Pure Value – TER 2.94%–has emerged a solid performer, delivering a big bang for the buck.

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Other expensive yet worthy funds include Birla Sun Life Special Situations, Mirae Asset Great Consumer, PPFAS Long Term Value, Franklin India Opportunities and Principal Growth. What these schemes clearly show is that a high expense ratio may not necessarily be bad news for investors and they should not ignore a fund simply because it has a high expense ratio. “If the fund is capable of delivering healthy alpha, or out-performance, on a consistent basis, then a few extra basis points as expense ratio should not really matter to the investor”, says a financial expert. On the contrary, if the fund is a laggard in its category, then it is not worth bearing a high cost for holding it.

The fund cost may become a crucial factor if you are choosing between two funds with similar return profile. “When deciding between two schemes with equivalent performance figures, the expense ratio surely comes into play, particularly in a bad market scenario”, says a fund manager.

What this study of `expensive’ funds reveals is that instead of ignoring a fund simply on account of a high expense ratio, investors would do well to look deeper into the fund’s performance history and the fund manager’s reputation. Astute stock selection and portfolio construction can make the expenses seem insignificant over the long run. So, performance should be investors’ priority when selecting funds. “Shortlist funds on the basis of performance and risk profile first. If you screen funds by the expense ratio, then you limit your universe to a narrow set of large-sized schemes and are likely to miss out on funds that are actually doing much better”, says the financial expert.

Source: The Economic Times

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