Will expense ratios of passive funds dip further?

By Ravi Samalad |  07-07-21 | 

At a time when a few Exchange Traded Funds (ETFs) and index funds are hiking the total expense ratio (TER), new players entering the industry are vying to get a slice of the pie of the fledging passive funds market by unleashing a price war.

Navi Mutual Fund, which acquired Essel Mutual Fund, recently launched Navi Nifty 50 Index Fund. It has an expense ratio of 0.06% in direct plan while the regular plan charges 0.26%. As of May 2021, Index Funds tracking Nifty Index have an average expense ratio of 0.25% under direct plans.

Securities and Exchange Board of India (SEBI) allows fund houses to charge up to 1% in index funds and ETFs but most fund houses charge less than this cap.

It is not that low-cost ETFs do not already exist in the industry. The lowest cost ETFs are CPSE and Bharat 22 ETFs, which are run on government mandate. Bharat Bond ETF managed by Edelweiss Mutual Fund charges 0.001%. Bharat 22 ETF run by ICICI Prudential MF charges 0.09%. Employees' Provident Fund Organization (EPFO) which invests in SBI Sensex ETF charges 0.07%. Similarly, SBI Nifty 50 ETF is charging 0.07%. Nippon CPSE ETF charges 0.01%. Nippon India ETF Nifty BeES charges 0.05%.

Will others follow suit?

We asked a few fund officials if the pricing war unleashed by new players will lead incumbents to cut down their TERs to remain competitive. They are of the view that most funds will refrain from cutting down TERs just to gain market share.

“The cost of running a passive fund is a function of expenses related to your team and infrastructure. We have a sister company which is a market maker. So we are able to save costs in market making. While TER is a major factor while choosing passive funds, investors should look at the tracking error,  trading volumes, brand name, assets under management as well. Funds may not reduce TER below a threshold where running the fund becomes commercially unviable. So I don’t see a rush to cut TERs in passive funds because some players are offering at a low cost. Funds that offer a differentiated strategy will charge a premium. Ultimately, market forces will decide the TER,” says Swarup Mohanty, Chief Executive Officer, Mirae Asset Mutual Fund.

Anil Ghelani, Head of Passive Investments & Products at DSP Mutual Fund, says that the TERs in passive funds are already competitive. “There are various costs associated with running an ETF namely: R&T, fund management, IAP, marketing, etc. Around 7-10 basis point is the bare minimum cost which covers the operating cost of an ETF, which would again depend on the strategy of the ETF. Smart beta ETFs could charge higher than plain vanilla ETFs. Investors also consider the brand and legacy of a fund house while investing and cost is not the only factor. We don’t envisage the industry aggressively cutting TERs in passive funds to gain market share.”

The ETF Head of a large fund house says that he does not see the trend of offering low-cost passive funds by new players as a threat. “I don’t think fund houses will take knee-jerk reaction by cutting TERs. Evolved investors like family offices, HNIs and wealth managers look at a variety of factors like the legacy and experience of a fund house, performance track record, liquidity before making investment decisions. You can’t base your investment decision merely on cost."

As on May 2021, there are 97 ETFs (excluding Gold ETF) that manage assets worth Rs 2.99 lakh crore while index fund asset base stands at Rs 22,904 crore. There are 47 index funds.

Here’s a look at the category average TERs of Indian ETFs.

TER of U.S. ETFs

  • Category Average TER (Unbundled or direct plan): 0.20%
  • Category Average TER (Bundled or regular plan): 0.41%
  • Category Average TER (Semi bundled): 0.47%

(Source: Morningstar Direct)

Choosing a passive fund

A higher TER eats into the net returns generated by the fund. Thus, a lower TER will translate into better return for investors, especially over the long term. If a fund generates 13% gross return and has TER of 2%, you will earn 11% net return. If the same fund has a TER of 1%, your net return will be 12%. The TER of funds goes down as the assets under management increase since economies of scale are passed on to investors. But should TER be the sole criteria for picking funds? “Cost considerations are important in investing, but it shouldn’t be the only or primary driver of investing decisions. Firstly, investors need to think about the suitability of the asset class/product in their portfolio form a risk-returns objective perspective, says Kaustubh Belapurkar, Director – Manager Research, Morningstar Investment Advisers India.

Lately, some passive funds are hiking expense ratios. Registered Investment Adviser Dev Ashish says that investors should not exit from a fund just because the expense ratio has gone up. “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?”

In this post, Dev answers questions on what investors should do if the TER goes up.

Read more about passive investing here.

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