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Annual Expenses Matter

If you havent done it till now, go and check out for the amount you are paying for the services provided by your fund

The annual results of asset management companies are out and forgotten. It's a yearly ritual - fund houses publish balance sheets and unitholders dump them in a waste paper basket. Yet, apart from the usual paraphernalia, these reports contain valuable information on expenses. Ironically, investors have scant regard for one of the most important issues in fund investing - how much they're paying for a mutual fund's services each year. A lower expense means that the fund is deducting less from the net assets, thereby pushing up the NAV. AMCs too are not very forthcoming with the cost of managing a fund and usually tuck them in some corner of the report. Hence, investors need to read the fine print.

What are annual recurring expenses?
An expense ratio indicates the percentage of assets that a fund deducts each year to cover management fees, administrative fees, and other operating costs. The expenses are charged to from the fund's average net assets and it accrues daily. Thus, other things being equal, two funds will deliver varying returns if their expenses differ. Consider two funds, A and B, where you hold an investment of Rs 10,000. While A charges expense of 2%, B has a cost of 1.5%. Clearly, you pay Rs 50 extra to fund A.

What makes up Expense Ratios?
Several components make up a fund's expense ratio. The largest component is usually the management fee. This fee goes to the AMC overseeing the portfolio to compensate the fund's managers, traders, and research analysts. Administrative expenses, which pay for things like mailing out prospectuses, annual reports and account statements, are also part of annual expenses.

Expenses cover a fund's distribution and advertising costs as well. On the other hand, entry and exit loads, contingency deferred sales charge or CDSC and brokerage fees that the fund pays for buying and selling securities are not included in the expense ratio.

Expenses and sizes
Expense ratios are capped at 2.5% of the average weekly net assets. This means that any cost overrun will have to borne by the mutual fund. Expenses normally go down as assets under management increase since the fund realises economies of scale. For instance, Rs 100 crore fund may charge 2.5% towards annual recurring expenses, which translates into an outflow of Rs 2.5 crore. However, if the fund were to grow to Rs 200 crore, even an expense of Rs 1.5% will mean a higher management cost of Rs 3 crore.

Further, a reasonable expense ratio depends on the type of fund. For instance, the recurring expenses are usually under 1% in passively managed index funds, which are run on auto pilot and hence, charge very low management fee.

The Current Scenario
Expense ratios are especially crucial in bond funds, where returns from most funds differ by a few basis points and gains accrue at a slow pace. Thus, it is advisable to opt for a fund with a lower expense, provided it is comparable on such parameters as credit quality of portfolio, liquidity and size. With heavy inflows in bond funds in the last couple of years, expenses have been typically on a decline. For the year ended March 31, 2001, the average expense for the medium-term bond fund is down to 1.55% from 2.18% for the year ended March 31, 2000. On the other hand, there are a few cases, where cost of management has actually gone up with a rise in size. This is largely attributed to aggressive distribution and advertising as bond funds slug it for fresh inflows.

For diversified equity funds too, the expense ratio has come down from an average 2.23% to 2.01% for March 2001. IDBI Principal Index is the cheapest equity fund with an annual expense of only 0.83%.

While investors currently pay little attention to expenses, the issue is likely to get prominence as competition intensifies and returns from funds converge. It is here that funds with relatively low expenses will use it as an effective market tool. After all, lower expenses means incrementally higher returns!