Costs affect businesses. A company that can't control its costs may either passes them on to the customer or absorbs them compromising on profitability. The situation is worse than you imagine in cases where compensation to the company is immediate, but benefits to the buyer tend to come in future. Puzzled? Consider the case of Mutual Funds or Asset Management Companies (AMCs).

Mutual funds have two types of costs - fixed and variable - much as that incurred by any other business entity. They are combined together and charged to the investor as an expense ratio. India stands among the countries which have one of the highest cost structures in mutual fund business at present. While mutual funds in the U.S. and Netherlands charge expense ratios of less than 1.0%; a few schemes in India charge as high as 2.75%. The average expense ratio is in the range of about 2.25%-2.50% in India. So, what makes Indian mutual funds so expensive when it comes to expense ratio?

Well, let's understand…

Cost structure of mutual funds in India
Variable costs include expenses such as brokerages paid, custodian costs and marketing expenses to mention a few. Fixed costs include salaries and compensation paid to top management. Suppose, every person in top management of an AMC is paid about Rs 80 lakh to Rs 5 crore excluding incentives and Assets under Management (AUM) are low; the fund house will find it difficult to breakeven as fixed cost will remain high in business. At this stage if it decides to pass high costs to investors, expense ratio will naturally be high. And fund houses which decide to absorb these costs, may have a pressure of expanding asset base rapidly to justify high costs.

Recently, the Securities and Exchange Board of India (SEBI) asked AMCs to submit their cost structure. This is an attempt to gauge the proportion of fixed costs involved in the business. There have been instances where AMCs have been forced to shut shops in the wake of high cost structure among other factors. The exit of foreign sponsored fund houses from India is perhaps one of the reasons for this.

PersonalFN is of the view that it is true that if salaries of those in the fund management league are reduced, it would have a positive bearing on the expense structure and bode well for investors in mutual funds. However, the rationality of this also needs to be gauged with relation to the performance track record of mutual fund schemes.

PersonalFN believes if low costs can translate into better performance for investors it should be welcomed as long as costs can be brought down without compromising on the quality of fund management, which is a win-win for the mutual fund house and the investors it serves. Fund houses which are already managing thousands of crores may be able to justify their high salary cost, but for smaller ones it may be challenge.

PersonalFN believes regulatory controls on specific costs may not help much. On the contrary, overall low expense ratio may prove beneficial to the investor.

For investors looking at reducing cost of investing while they invest in mutual funds, direct plans would be appropriate; but one needs to select mutual funds wisely as well. In case you don't know which schemes you should invest in, it may help to take an expert's advice.

Add Comments