As expense ratios rise, should you exit your index fund?

By Larissa Fernand |  15-04-21 | 

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.

  1. 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?

  1. 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

  1. 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.

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Murlidhar Prabhu
Apr 17 2021 06:27 PM
 I agree in totality with views expressed by Ninan Joseph
ninan joseph
Apr 17 2021 02:58 PM
 I read an article on September 12, 2019 by Deepesh Raghaw of personal finance plan as to how Aditya Birla Sun Life Fund increased their commission from 0.20% to 0.60% by giving a simple notice. When asked they reverted saying the rise was temporary and that the rate will be brought down. The point is by doing nothing great, they increased their income by 60 crore. The best part is the money is already with them, they dont need you to fund the additional commission, they just take it so they have it all. If a fund house is not doing well, all they need to do is increase and say it is temporary.
The point being, just like you do screening about promoters, you need to know who the AMC you are going to place your money with.
As the author rightly said, if you move from one fund to another, then there is no guarantee that the other fund will not increase. The best option is to do things yourself and go for ETF which is Nifty or sensex backed and who has a fairly large AUM. Not sure if there is cap for commission on ETF.
When you move from funds to funds, you need to worry about tax implications as well and not only commission. Hence it would be better to do little research on the AMC before investing.
As a retail investor, it would be impossible for us to find out. These are the areas where Morning star should take the lead and write about the history of commission increase/decrease of a fund when they do a review. This would be a good data base to have as well. Similarly with regard to corporate governance, a review of a fund or a company should include these.
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