There has been a backlash on Twitter regarding Morningstar’s stance on the expense ratios of the Indian mutual fund industry.
We have been accused of waging war on the advisory and distributor community.
Nothing could be further from the truth.
We are committed to the growth of the funds industry globally and work closely with all stakeholders, including the fund companies, advisers and investors.
At Morningstar, we prudently take cognisance of countering views and opposing feedback. We now seek to reiterate our views in the proper context.
The context
Without a context, there can be no fruitful narrative.
In the Morningstar Global Fund Investor Experience Study 2017 (GFIE 2017) which seems to be the bone of contention, our research team evaluated practices in 25 countries on the basis of:
- Regulation and Taxation
- Disclosure
- Fees and Expenses
- Sales
The study is an independent analysis of the fund investor’s experience across different markets and ranks each country based on 83 questions. India achieved an overall grade of Average, ahead of many European markets and equivalent to many developed markets. India received the highest grade of Top for Disclosure but was rated Below Average under Fees and Expenses. India did NOT receive the lowest grade for Fees and Expenses, and was one of 9 countries to receive a Below Average grade in this area.
We have always been emphatic that the purpose of the study is to promote dialogue amongst the industry participants about what constitutes best practice. Hence, we categorically state that the “us against the Indian funds industry” slant is completely baseless and unfounded.
Our unwavering focus is to champion the individual investor and empower the advisory community that serves them.
The challenge our study puts out is how can we continue to improve the investor experience. Because if the investor wins, everybody wins, including the intermediaries that serve them. Hence our unchanging posture that the investor is our True North.
Morningstar’s perspective
While the GFIE 2017 states that India is amongst the most expensive geographies when it comes to expense ratios for equity and allocation funds, and these elements fall behind global best practices, it also goes ahead to state that the situation “is not unusual given the developing nature of the Indian fund market and the impact this has on scale and distribution.”
Indian investors do not pay front loads when acquiring funds and the expense ratios for fixed-income funds are globally competitive. India also prohibits funds from charging performance fees, which removes issues around the structuring and disclosure of such fees.
Based on the above, the GFIE 2017 grade for India was Below Average.
If a pure expense ratio number had been the only criteria, India would have received a grade of Bottom for Fees and Expenses.
Given the level of alpha that Indian funds deliver, there isn’t always enough focus on the absolute level of expenses charged by funds.
We think as assets under management grow, asset managers should focus on passing on the benefits of economies of scale to investors by reducing expense ratios. As the adoption of direct share classes increase with investors paying for advice, there will be a natural migration towards lower costs of fund ownership and greater value added advice for investors.
The apparent controversy
It has been stated that the GFIE Report has compared cost of bundled funds (embedded funds) and unbundled funds without making the necessary adjustments to make them comparable.
Over the last two reports, Morningstar has openly called out the issues related to bundled versus unbundled fee comparisons. For the purpose of this study we have also taken the stance that unbundled fee structures are better for investors than bundled structures.
There are three main reasons for this (not just India, but all markets):
- It provides better disclosure
- There is more focus on each part of the value chain
- Cheaper funds become available to investors.
An ongoing service fee negotiated with a client is likely to result in better services provided to the investor than a trail commission automatically paid by a fund. Likewise, a fee for initial advice agreed with a client is better than a front load.
Some challenges with the assumptions made in the FIFA report
- In India, 16% of the equity assets come from direct plans. If FIFA has chosen to add an assumed advisory fee component to costs in other geographies, they should do the same for direct plans for equity funds in India. As described above, we do not believe this approach makes sense for comparison purposes.
- The FIFA study excluded the tax component (VAT/GST) from the expense ratio. We are not sure how prudent a move that is as the burden will invariably fall on the investor, and there is no way that s/he can avoid it. To provide an analogy of sorts, the price of petrol is high in India, when compared to other oil importing countries, due to the imposition of VAT and central excise duty. It would be unrealistic to take away those components and then make a statement that costs are relatively cheaper.
- FIFA assumed a flat 1.25% administrative and advice fee which is added to all the unbundled markets. Is 1.25% truly a representative number? In the GFIE 2015 report, we pointed to a range of 1% - 1.5%. Clients could choose an administration platform or an advisory, or none. Hence, a generalization is questionable, specially one as high as 1.25%. To give a perspective, 36% of investors in the U.S. do not seek financial advice and do not pay any advisory fee. Consequently, there is no ONE number that can be employed as the advisory fee and the average advisory fee can’t be calculated without knowing what percentage actually pay for advice and how much.
- FIFA has assumed a 50bps load on all funds in markets where load funds are available, and then applied it proportionally taking the number of funds reporting a front load. We think this is flawed as loads are negotiable and it is not possible to state with complete accuracy the number of investors who are paying loads and in what quantum. Specially given the trends on investors switching towards no-load funds.
- Another issue with this treatment is that the load adjustments, if any, need to be applied based on assets invested in load funds and not by the number of funds. Again, to provide a perspective, in the U.S., 21% of funds report front loads but the assets in these funds are around 10%. And the amortization of the load data over 3 years in international markets rests on the assumption that an equity fund is only held for 36 months. Similarly, in Australia, while a small percentage of funds on the database have a front load, these funds have not received any new investments in the last three years as commissions have been banned.
- GFIE calculation of net asset weighted median expense ratios in unbundled geographies also includes a large share of historical assets already invested in bundled share classes. Thus, again adding advice fee and loads on top of these numbers results in a double incidence of these expenses.
- We also question FIFA’s assumption that the difference between the expense ratios of regular plans and direct plans is the distribution cost in India. Data on actual commissions paid to distributors is available. An examination of the factual data is likely to be more instructive than assumptions.
Our study has pointed out that these are asset weighted medians of all funds and meant to provide an indicator for the average investor. To perform analysis trying to represent the experience of a specific class of investor additional exclusions would need to apply. In this example, one would need to look specifically at the median fee of funds used in unbundled arrangements and exclude those with bundled fee structures. Even then, layering on advice and platform costs to this number would be problematic without additional research on what figures are being charged.
What makes for a good fund experience?
Morningstar has many views about what makes for a good experience for fund investors.
As a general rule, we favour active regulation of funds, low tax burdens on investors, increased disclosure, lower fund fees, a varied distribution system that gives investors many ways in which to purchase funds, and media coverage that helps to educate investors.
Globally, we are witnessing continued downward pressure on fees in many markets. Taken together, bans on (or substantial waivers of) sales loads, continued decoupling of fund expenses from advice charges, bans on commissions, plus mandatory fee transparency, have resulted in a great many investors paying less for funds than ever before. However, the move toward lower total investing costs is anything but linear.
While the costs of certain investment products are declining, and relatively cheap exchange-traded funds are proliferating, investors are in some cases still paying as much to own a portfolio, as lower costs for investments are negated by higher costs for advice. Advice fees can vary by investor, advisory firm, and account type. We also know that good advice is valuable for investors. We maintain that by lowering the cost of investment products via commission-free share classes and by unbundling other expenses from the cost of investment management, transparency improves and investors benefit.
In addition to lowering all-in costs for do-it-yourself investors, those participating in a fee-based advice model may accrue additional benefits from more-individualized service, including savings guidance, tax planning, and pension optimization, which collectively add significant value to the investor experience. If it is clear that an investor is paying for advice, then they are more likely to receive better quality advice.
In conclusion
The GFIE was never meant to be a definitive study on expense ratio levels. Rather, it was a measure of investor experience and the aim has been to promote healthy dialogue about what constitutes best practice. We are glad that the India market has taken cognizance of the report and is debating best practice.
There are challenges comparing bundled with unbundled markets, but what could not be determined with surety, did not form part of our analysis as that would lead to a misconstrued conclusion.
Ultimately, any change will be driven by market participants in individual countries. The challenge this study puts out is how can we continue to improve the investor experience.
We firmly stand behind the grades that were issued.
