TLDR: A expense analysis of ETFs vs. Mutual funds

  AMFI - Association of Mutual funds of India is the industry body created with some noble goals (as per their website). They have some very useful information on their website on mutual funds. They also have done an excellent job in marketing mutual funds to the general public under the “Mutual Funds Sahi Hai” ad campaign.  You got to be living under a rock if you have not seen that ad while watching Indian television.

  It is no surprise that this has led to some impressive growth numbers for mutual funds from the retail sector.

If we are to stick to equity funds, what  is the participation of retail investors?

More than 95% of the Folios and 51% of total invested as of Sep 2018 based on the AMFI self reported data.

Mutual Funds - Fee structure

      Most of you would have heard the term - TER (Total Expense Ratio) for mutual funds. SEBI the regulatory body has created some rules around the maximum allowed TER based on the fund size and types of fund. But before we go there, what are the TER components

1. Fund management fee

2. Distributors’ fees/ commission (To avoid this, use direct plans instead of regular plans)

3. Marketing expenses

4. Trustee fee

5. Registrar fee

Source : Economic Times

Compared to the good old days with entry load and exit loads, no direct plan, these expenses are reasonable. But there are a few issues that don’t come to light here.

1) Fund turn over

Typically most actively managed equity mutual funds have a high fund turn over, meaning they buy and sell the underlying stocks quite frequently. I am unable to find a clear definitive industry average turn over.  I will take one example as a reference here.

ICICI Prudential Bluechip Fund

  This fund has been in existence for more than 10 years. AUM of more than 19,000 Crores with an expense ration of 1.21% as per the data from value research oneline. The one key metric is the fund turn over which is 132%. So essentially what that means is that every year more than entire portfolio of the fund is bought and sold. Even for a fund with such a big size and trustee like ICICI, there are costs involved in selling 19,000 * (1.32  / 2) (132% - turn over) crores worth of stocks and buying back an equivalent amount in a year.

These expenses are going to be passed on to the investors. This is typically not included in the TER that is shown in the figure. Even if this is only 1% expense, things add up.

So the overall cost to the investor is 1.21% TER + 1% in transaction fees(brokerage+stamp duty +STT for both buy and sell legs) for the fund turn over. So in total close to 2.21% lost.

2) Ratio of regular / direct funds

    The above 2.21% loss to the mutual fund house is based on the assumption that the investors are investing in direct plans, but the reality is different.

Most retail investors still invest via distributors and not directly. So they end up spending anywhere between 0.75% to 1% extra than direct plans. Take the case of ICICI blue chip fund in the previous example

TER for Direct plan = 1.21 %

TER for regular plan = 1.96%

A difference of 0.75%, every year that keeps compounding as well. If you want to understand the impact of this expense compounding look at my blog post on this topic.

3) Fund performance over a long term - RTM
      Reversion to the mean - this is one of the topics of John Bogle’s book called “The little book of common sense investing” which covers this topic in detail. I am planning a blog post on this book shortly. Circle back to the blog in a few week’s time if you want to know about it. The premise of the book is that funds cannot consistently beat the market over the long term.  After a period of time they revert to the mean. If a fund has been beating the underlying index over say 5 years, it will lose its shine and revert back to lagging the index soon and the mean performance over the long term would generally be lesser than the index itself. Will cover these topics in more detail in the upcoming book review.

ETFs

ETFs (Exchange Traded Funds) have not captured the imagination of the retail investors like mutual funds. In all honesty the index funds are in their infancy when it comes to the Indian market. But that doesn't mean they are not serious contenders as investment options compared to mutual funds. I have posted quite a few articles about index funds already including my own index portfolio, options for ETFs in India and how to buy them cheaper than the market price.

The key benefit that i see for ETFs is much smaller expense ratio typically less than 1% and no other expenses except for brokerage costs / STT for the buy and sell leg of the transactions. So the costs are typically much lesser than mutual funds.

But given the fact that we don’t really have an S & P 500 equivalent ETF to track BSE 500, you might need to use a combination of funds to achieve the same level of diversification.

In summary, there is still room for mutuals funds and index funds in the Indian market. But i am leaning more towards ETFs and index funds than mutual funds to set the tone for the future as more players are bound to launch more ETFs and there is better awareness of the benefits of ETFs.

What is your take? Do you have any favourites in either direction? Leave your comments below.

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