Index Funds raising Expense Ratio. What should index fund investors do?

Some popular index funds in India, namely HDFC Index Fund-NIFTY 50, HDFC Index Fund-Sensex Plan and UTI Nifty Index Fund have decided to raise the expense ratios

Increasing or decreasing of expense ratio is a common event in the mutual fund space. But when index funds (which are known and at times chosen for their low expense ratios) raise their expenses, it becomes a topic of discussion.

Many investors are unhappy with this move by HDFC & UTI AMCs which are quite popular among index fund enthusiasts.

As per the information received, UTI Nifty Index Fund will raise its expense ratio from 0.10% to 0.18% for the direct plan while it will be increased from 0.14% to 0.28% for the regular plan. Similarly, HDFC will increase it for HDFC Index Fund-NIFTY 50 Plan from 0.10% to 0.20% for the direct plan, while the regular plan expense ratio will be increased from 0.30% to 0.40%. The same quantum of increase will be done for direct and regular plans of HDFC Index Fund-Sensex Plan respectively.

Related reading: List of Index Funds in India

Index funds are primarily chosen on the basis of corpus size, low tracking error, low expenses, etc. So even though the whole idea of index funds is to replicate the index returns, people still look for the best index funds to invest in. And above-mentioned ones are just a few of the important factors to consider.

So why such noise around the expense ratio?

An increase in expense ratio (TER) impacts the fund returns for the investors in the long term. Understand it with two simple hypothetical examples.

The expense ratio states how much the investor pays as a percentage of the investment every year to AMC to manage and invest their money.

So if you invest Rs 1 lakh in a mutual fund with an expense ratio of 1%, then if the fund earns 15% during the year, for the investor it would mean a return of about (15% – 1%) = 14%. Remember that the fund NAVs are reported net of fees and all other expenses. A small figure of 1% may not seem big. But over the long term, it starts to hurt.

Here is how this impact you over a 15-year period.

Suppose you invest Rs 1 lakh and the fund generates (before expenses) about 15% every year. So after 15 years, the value would be about Rs 8.2 lakh. But if we consider an expense ratio of 1%, the actual value of the investment will be Rs 7.1 lakh (instead of Rs 8.2 lakh). So lower the expense ratio, the better returns the investor actually gets.

So why do AMCs increase the expense ratios of their funds? More so why for index funds where there is no active fund management or skill involved as the only job fund manager has is to replicate the index returns by mirroring index portfolio?

For having some control over the expenses that the AMCs charge from investors, SEBI has stipulated the upper limits. The maximum permissible limits for the expense ratio now depend on the assets under management (AUM) of the fund.

  • AUM of Rs 0-500 crore – 2.25%
  • AUM of Rs 500-750 crore – 2.00%
  • AUM of Rs 750-2000 crore – 1.75%
  • AUM of Rs 2000-5000 crore – 1.60%
  • AUM of Rs 5000-10,000 crore – 1.50%
  • AUM of Rs 10,000-50,000 crore – TER reduction of 0.05% for every increase of 5,000 crore AUM or part thereof
  • AUM of Rs 10,000-50,000 crore – 1.05%
  • For index funds & ETFs – 1.00%

Note – Direct plans will always have a lower expense ratio than regular plans as these are sold directly to investors without any payment of commission to the mutual fund agent (like in regular plans). As a result and always, direct plans give higher returns than regular plans of mutual funds. 

It is worth reminding that the AMCs are in the business of making profits. So at all times, they would want to maximize it. That’s a natural thing to do. So I think the only occasion they would reduce the expense would be to attract fresh investments to increase their AUM. Once the AUM is increased to a level they feel good about (profit-wise) they will increase the expense again. And vice versa, when AMC feels that it needs more AUM to increase its income, it will again reduce the expense ratio to attract fresh investment from expense-conscious (Index) investors.

So if you are picking index funds only on the basis of the lowest expenses, then you got it all wrong. You might pick an index fund with the lowest expense ratio one day and start investing. After a few months, the fund house may increase the expense. Now your fund is not the cheapest index fund out there. Will you exit?

It is for this reason that you should not just blindly invest in the cheapest index fund available.

This obsession among many to choose index funds on basis of the lowest expenses only should be stopped immediately. If you have to choose index funds in India, also look at tracking errors (lower is better), AUM (bigger is better), in addition to reasonably low expense ratio. Also, stick to the larger indices only, something like Sensex Vs Nifty 50 index funds or Nifty Next 50 index funds.

If in near future your Index fund increases the expense ratio, it doesn’t mean that you just sell everything. Stay put.

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Across the world, expense ratios are coming down. Going towards zero! But in India, AMCs are still playing games. 🙂 But I think eventually, competition will take care of this.

Though there is nothing for investors to do now, I think eventually SEBI should consider addressing this issue of frequent expense ratio changes by AMCs soon. This can’t go on unchecked forever. In 2018, SEBI did ask AMCs to ensure that the investors are notified about changing expenses every time. And AMCs are doing that. But SEBI should also bring in some rule that says that expenses can only be changed a few times a year and not whenever the AMC wishes to do so.

Some investors are now thinking about whether it makes sense to switch to passive ETFs as the expense ratio of their index funds has increased. I think it’s still too early to jump the ship for now. ETFs no doubt have a lower expense ratio than index funds. But ETFs have some issues due to their structural nature and how they are bought and sold. At times, there can be significant deviations of the ETF unit price from the NAV. And this can be a showstopper for investors as due to these NAV-price discrepancies, the investor may not be able to buy or sell at a chosen price.

So I would say that despite the increase in TER for few popular index funds, the fact is that there is not much you and I can do. And if TER has increased today, it can be brought down in future too. And if it’s any consolation, the TER is still much lower than active funds. Right? So relax and live with it. 

Related Reading – Do read index funds vs large-cap funds to understand how and when you should pick index funds over actively managed funds.

All said and done, don’t worry too much about things that are not in your control. If index funds are raising expenses then remember that SEBI too knows about this. And if it feels that something needs to be done, SEBI will come out with some directives for the AMCs. As for you, don’t run after looking for the best index mutual funds with the lowest expense ratio in India. Just pick one amongst the reasonable ones and move on with your life.

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