Uniform Expense Ratio

Many retail investors are often not aware of the fact that they are paying a higher expense ratio than institutional or corporate investors for investment in the same fund. The expense ratio that they are paying could be 0.40-1.00 per cent higher than what the institutional investors are paying. 

Asset management companies (AMCs) usually charge a lower expense ratio from institutional investors. Their logic behind charging differential expense ratios is that the amount of efforts and cost in collecting money from retail investors is much higher than raising money from institutional customers.

The Securities and Exchange Board of India (Sebi) has questioned the practice of charging differential expense ratios across different investor categories when the portfolio is same. The regulator has asked fund houses to charge a uniform expense ratio irrespective of the size of investment. The regulator has also asked fund houses to charge a uniform load on early exits from funds. At present, most fund houses do not charge an exit load on investments over Rs 5 crore.

What is an expense ratio? 
It is a fee charged by a fund house to manage and operate the fund. The charges include management fees, administrative fees, and other operating costs. The expenses are charged from the fund's average net assets. 

Other things being equal, two funds will deliver varying returns if their expenses differ. If there are two funds charging expense ration of 2 and 1.5 per cent, then an investor investing Rs 100,000 in each fund is paying Rs 500 extra in the first fund as expense ratio. The return, therefore, diminishes in the first fund accordingly.

At present, the expense ratio is capped at 2.25 per cent for equity funds and 1.75 per cent for debt funds with further sub limit on different category of expenses.

Current practice
Usually, a mutual fund scheme collects money under three different plans – retail, institutional and super institutional -- with the minimum investment amount varying for each category of investors. In most cases, the minimum amount of investment is Rs 5,000 in retail plans, Rs 1 crore in institutional plans and Rs 10 crore in super institutional plan. However, in some cases the minimum amount may differ. While the practice is common in debt funds, especially liquid and ultra short-term funds, as large corporate houses and banks park their surplus cash in such funds, there are many equity diversified funds, which also follow the differential expense ratio structure.

The logic behind differential expense ratio is based on the simple business principal – larger (wholesale) customers getting the cost benefit, while small (retail) customers paying higher.  

The average cost of acquisition of a mutual fund investor is typically in the range of Rs 50-70 that includes form cost of Rs 2-3, registrar and transfer (R&T) cost of 0.007 -0.01 per cent of the fund corpus for equity/0.002-0.004 per cent for debt funds and fund accounting charges 0.0015 per cent. “The average size of a retail investment is Rs 10,000. Therefore, to collect Rs 10 crore, we need to sell the scheme to 10,000 retail investors that would incur a cost of Rs 5-7 lakh. The same amount can be raised from 10 institutional investors or just a super institutional investor. In doing so, we incur maximum cost of Rs 500-700,” said chief executive officer of a fund house.

He further said that since the cost of acquisition is lower in the cases of institutional investors, they try to pass on the benefit to large investors by lowering the expense ratio. 

Sudipto Roy, business head, Principal PNB Mutual Fund, said, “Wherever funds have more than one investors class (based on minimum investment size), higher expenses are charged to investors with lower ticket size and lower to investors with higher ticket size (generally institutional investors). This is especially true for liquid schemes, ultra short term schemes and short term plans. While the management fees are changed on a uniform basis to all the plans, the operating expenses are charged differently.”

The sore point
However, in mutual fund, the money collected from different categories of investors is pooled together to form a portfolio, thus exposing one category of investors to the action of another. With institutional investors sparred of paying even exit loads, any redemption from one or two such investors can seriously undermine the interest of other investors in the fund.

For example, if a mutual fund scheme has Rs 100 crore in asset under management and a couple institutional investors make an early exit from the fund bringing down the AUM to say Rs 60 crore, the existing investors in the fund will not only bear the additional expenses of the fund but also take a hit due to negative sentiments.

Differential expenses
When Value Research dug out data of expense ratios charged by different fund schemes, it found that many equity funds charge retail investors up to 80 bps more as expense ration than that of institutional investors. The difference in case of liquid and ultra short-term funds is usually 40-50 bps. For example, Sundaram BNP Paribas Ultra Short Term Fund was charging an expense ratio of 1.03 per cent from retail investors, 0.56 per cent from institutional investors and 0.25 per cent from super institutional investors as on March 31, 2010. In equity schemes, AIG India Equity retail plan was charging an expense ratio of 2.31 per cent, while the institutional plan was charging an expense of 1.55 per cent.

Way forward
With the Sebi asking fund houses to do away with differential expense ratios, some in the mutual fund industry want the regulator to allow them to segregate money from retail and institutional investors into different funds instead of merging them in one fund. 

According to a mutual fund CEO, in liquid and ultra short-term funds the returns are anyways in 4-5 per cent range and if they don’t give the 0.40-0.50 per cent cost advantage to large investors, these funds would become unattractive for them. “We won’t mind uniform expense ratios in equity funds as returns from such funds are higher and a 0.50 per cent drop won’t make much of a difference to investors,” he added.