The Indian mutual fund industry has grown significantly, attracting investors looking to participate in the equity market without needing substantial expertise. A key parameter investors often consider before selecting a fund is its Net Asset Value (NAV). NAV reflects the market value of a mutual fund’s portfolio, less liabilities, and is a critical yardstick for determining performance. However, another crucial element often overlooked by investors is the Expense Ratio in Mutual Funds, which contributes heavily to influencing returns.
One phenomenon commonly observed in the mutual fund space is that actively managed funds tend to have higher Total Expense Ratio (TER) compared to their passive counterparts. This article explores why actively managed funds command higher fees and how it impacts NAV and overall returns.
What Is a Total Expense Ratio?
The Expense Ratio in Mutual Funds is essentially the annual fee charged by fund houses to manage the investment portfolio. It is quoted as a percentage of the fund’s average assets under management (AUM). The
Total Expense Ratio includes various costs like fund manager remuneration, transaction fees, marketing, bookkeeping, auditing, and legal expenses.
For example, if the average AUM of a mutual fund is ₹100 crore, and the total expense incurred is ₹2 crore, the expense ratio will be:
\[ \text{Expense Ratio} = \frac{\text{Expense Incurred}}{\text{Average AUM}} \times 100 \]
\[ \text{Expense Ratio} = \frac{2}{100} \times 100 = 2\% \]
The TER is deducted from the fund before calculating the NAV, thus directly affecting investor returns.
Active vs Passive Fund Management: The Expense Equation
To understand why actively managed funds often have a higher TER, it is crucial to evaluate the operational differences between active and passive fund management.
1. Investment Strategy
– Active Funds: Actively managed funds deploy professional fund managers who continuously research, analyze, and tweak the portfolio to outperform the market. They focus on stock-picking, sectoral allocation, and dynamic adjustments to enhance returns.
– Passive Funds: In contrast, passive funds (like index funds and ETFs) simply mirror or replicate a market index like the Nifty 50 or Sensex. They don’t require active intervention or frequent adjustments.
Due to the intensive activity in actively managed funds, fund houses spend significantly higher resources on research and personnel, which translates into a higher expense ratio.
2. Management Costs
Fund managers of actively managed schemes often hold years of expertise and specialized knowledge, commanding higher salaries and incentives. These funds also incur brokerage fees for frequent buying and selling of stocks to align the portfolio with market movements or anticipated trends. All of these costs contribute to a higher TER, thereby impacting NAV.
3. Frequency of Transactions
Passive funds, by their nature, practice minimal trading as they’re structured to replicate an index. This results in significantly lower transaction and exit costs, reflected in a lower TER. In contrast, active funds may trade extensively, incurring higher transaction charges due to frequent buying and selling. These expenses get absorbed in the fund’s TER.
4. Marketing Expenses
Actively managed funds often have aggressive marketing campaigns to differentiate themselves from competitors. The marketing and promotional activities aimed at attracting investors contribute to increasing the total expense ratio.
Impact of Expense Ratio on Net Asset Value (NAV)
NAV is calculated by taking the fund’s total asset value, subtracting any liabilities, and dividing this by the number of outstanding units. A higher expense ratio means more expenses are subtracted from the fund’s portfolio, resulting in a lower NAV.
For example, consider two funds with similar performance, but differing TERs:
– Fund A: TER = 2%
– Fund B: TER = 0.5%
If both funds have assets worth ₹500 crore and liabilities at ₹50 crore, NAV before expenses will be:
\[ \text{NAV (pre-expenses)} = \frac{\text{Total Assets – Liabilities}}{\text{Outstanding Units}} \]
\[ \text{NAV (pre-expenses)} = \frac{500 – 50}{500} = ₹9 \text{ per unit} \]
After accounting for respective TERs, the NAV adjustments would look like:
– Fund A: NAV = ₹9 – (2% of ₹9) = ₹8.82
– Fund B: NAV = ₹9 – (0.5% of ₹9) = ₹8.955
Fund A’s higher TER results in a noticeably lower NAV, directly impacting investment returns.
Expense Trends in Indian Mutual Funds
In India, actively managed equity funds typically have TERs ranging between 1.5% and 2.5%, while passive funds like index funds have TERs as low as 0.2% to 0.5%. The Securities and Exchange Board of India (SEBI) has set upper limits on TERs to maintain investor transparency and fairness. However, the regulatory cap varies based on the size of the fund’s AUM.
The Choice Between Active and Passive Investing
Actively managed funds try to beat market benchmarks, but their higher TERs and the overall expense ratio in mutual funds can eat into returns over time, especially if the fund underperforms. Passive funds run with lower fees, though they only aim to mirror market performance.
The choice between active and passive investing should line up with your expectations, risk appetite, and long-term goals. It helps to remember that higher TERs don’t guarantee better results.
Summary: Why Actively Managed Funds Often Have Higher Total Expense Ratio
Actively managed funds tend to have higher Total Expense Ratios (TER) as compared to passive funds due to their investment strategy, higher management costs, frequent transactions, and marketing expenses. This higher TER influences the Net Asset Value (NAV), often reducing investor returns. Active management involves extensive research and stock adjustments by fund managers aiming to outperform the market, factors which cumulatively increase costs.
For instance, funds with higher TERs experience greater deductions, leading to a lower NAV compared to passive funds with minimal overheads. Indian equity funds typically have TERs ranging from 1.5% to 2.5%, making it crucial for investors to weigh these factors carefully.
Disclaimer: This article is not a recommendation and serves educational purposes only. Investors must critically evaluate all pros and cons before trading in the mutual fund market, considering risks and personal financial goals.
