In 2016, there was a rush by passive funds to lower their expense ratios. This was done with one goal in mind – to attract investment from the EPFO.
Here’s the context: The Employees’ Provident Fund Organisation had taken a decision to invest in equity via passive funds. To be a suitable “destination”, fund houses began cutting down the expense ratios of their passive funds.
The expense ratio is an annual fee charged to investors to cover the expenses of mutual funds. It is expressed as a percentage of your investment and deducted from the amount you invest in a fund. You pay it irrespective of whether the investment does well or not, or the state of the market. Remember that the net asset value (NAV) of every fund is reported net of expenses.
Now in 2021, the reverse is happening. The expense ratios of passive funds are increasing. And investors are wondering if they should exit.
Registered Investment Adviser DEV ASHISH answers three questions on this subject.
- Should investors in the passive funds jump ship?
There are two aspects to this.
- Should investors exit passive funds because of the rise in expense ratios? The answer is No.
One of the strong factors in favour of passive funds is the low expense ratio in comparison to other actively managed equity funds. That does not change. When it comes to passive funds, the maximum expense ratio allowed to be levied is 1%. In the case of other equity funds, it ranges from 1.05% to 2.25% depending on the assets under management. Greater the number of assets, lesser is the amount to be levied.
- Should investors exit their fund for another passive fund that is cheaper? The answer is No.
There would be a solid reasoning as to why you invested in one particular fund. It could be the expense ratio (lower the better), tracking error (lower the better), assets under management (bigger the better), and the benchmark index (preferably stick to the large ones).
Just because the expense ratio has inched up slightly is not sufficient justification to jump ship. Also, if you sell your units and invest in a fund with a lower expense ratio, is there any guarantee that it will not increase it tomorrow? If so, will you then exit that one too?
Active or Passive: Which is better?
- Should you switch to an ETF?
Exchange Traded Funds have lower expense ratios than index funds but are structured differently.
When you buy and sell units of an index fund, it is based on the declared NAV. Not so in the case of ETFs. There can be significant deviations between the ETF unit price and its NAV, due to the lack of liquidity.
The spread is the difference between the price you pay to acquire it and the price at which you can sell it. For some ETFs, the spread can be quite large. There is nothing you can do about it. And due to these NAV-price discrepancies, the investor may not be able to buy or sell at a chosen price. This impact cost must be taken into account.
5 things to look for in an ETF
- How impactful is the increase?
So if your investment earns 15% during the year, but the expense ratio is 1%, the return is actually 14% (15% – 1%). But it is most impactful over long periods of time. Let’s look at an example.
- Amount invested: Rs 1 lakh
- Tenure: 15 years
- Return: 15% per annum
- Amount after 15 years: Rs 8.2 lakh
- Amount after 15 years @1% expense ratio: Rs 7.1 lakh
Lower the expense ratio, better the returns. That is one of the biggest draws of a passive fund. The longer the tenure of the investment, the greater the impact.
