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Mutual Fund Analysis

December 10, 2011

Impact of Expense Ratio, Turnover Ratio and Load on Returns from MF schemes: Overview: Mutual Fund investors have to have a close look at the key terms such as Expense ratio, Turnover ratio and loads while investing as these have an impact on the net returns of the mutual fund schemes. They are the costs that are charged by the mutual fund companies, influencing the scheme's consistency of returns over periods. The Expense ratio and Turnover ratio are deducted while calculating the net asset value whereas the loads are deducted from the proceeds, all impairing the returns of the mutual funds schemes for an investor. A brief note on these charges is as follows: 1. Expense ratio: Expense Ratio is a total annual cost charged by mutual fund companies to manage investors money. Expense ratio, expressed in percentage form, is calculated by dividing the operating expenses by the average daily or weekly net assets. It is calculated or estimated on an annual basis and deducted from the net assets on a daily basis. That means, the NAV of a scheme is declared on a daily basis after deducting the expenses. Components of Expenses: a. Annual Management Charge (charged by the fund manager for managing the fund), b. Trustee Fee, c. Audit and Legal Fees, d. Administration and Operational e. Transaction Fees. The asset management company which manages the fund, the custodian who is responsible for maintaining the funds and securities, the R&T agent who maintains the investor records, distributors who bring the investors to the fund, the trustees, the auditors, all charge a fee for their services. For example, if a pool of Rs.100 crore is invested and is worth Rs.120 crore after a year. The return is 20%, but this is before charging costs. If the fund charges a cost of 1% on the portfolio, the value of the portfolio would be Rs.119 crore and the return would be 19%.
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Expense ratio measures the total cost of investing in a fund for an investor. Generally, a fund with lower expense ratio is considered more attractive than the one with higher expense ratio. Impact on schemes returns: Performance of mutual fund schemes is affected by expense ratio since it is deducted from the net assets. Further, the returns are affected more by the higher expenses if the investments are held over long term. The chart shows the difference in the returns by three schemes with different expense ratios for the time horizon of 25 years. The returns are impaired more by higher expense ratio in long term holding. In a nut shell, mutual fund schemes with lower expense ratio would provide better returns over the long run compared to schemes with higher expense ratio. High Expense Ratio impairs the performance of Mutual Funds:
1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 1 4 7 Grow th at the rate of 10% CAGR 10 13 Fund A (1%) 16 Fund B (1.5%) 19 22 Fund C (2%) 25

Impact of Expense ratio on different categories of Mutual fund schemes: On Equity oriented schemes: The impact of expense ratio on equity oriented schemes is lower than that in the case of debt funds as the return expected from the schemes is significantly higher than expense ratio.
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On Equity Index schemes: The performance of index fund is dependent on the expense ratio and tracking error. Tracking error indicates how closely the index fund return matches with of the underlying tracked index. The index funds are passive funds requiring less effort to manage them. Hence the expense ratio in such schemes is lower than that in equity diversified schemes. On Debt schemes: In debt mutual fund schemes, expense ratio is an important parameter to consider. The gross return from debt mutual funds are in the range of 5% to 9%, so expense ratio of 0.5% to 1% will have significant impact on the net return of the debt fund scheme. In case of liquid and ultra short term schemes, the returns are even lesser and even small differences in the expense ratio of schemes can make significant impact on their net returns. SEBIs regulation on Expense ratio against the corpus: Mutual Fund Regulations specify the maximum limit of the expenses that can be recovered from the investors every year. For equity schemes the maximum limit that can be charged is 2.50% of the assets of the fund while for debt funds the limit is 2.25%. This is 1.50% in case of passively managed funds such as index and ETFs. Depending on the type of scheme and the net assets, operating expenses are determined by limits mandated by the SEBI Mutual Fund Regulations, which are as follows;

The above table shows that the expenses of the scheme decreases if the corpus increases. So, investors may also consider the size of the funds while making investment decisions. SEBI specifies only those expenses that can be directly related to a scheme, such as investment management fee, custodian, R&T agent and other constituents, can be charged to investors. The investment management fee is a part of these total costs and cannot exceed 1.25%. Exclusions: Costs of maintaining offices, employee costs, technology used in its office and general marketing expenses cannot be charged separately to the scheme. Such expenses are borne by the AMC out of the investment management fees that they charge to the scheme.
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Category wise best performing schemes having Highest and Lowest Expense Ratios: Equity Diversified Large Cap:

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Equity Diversified Mid & Small Cap:

Equity Diversified Multi Cap:

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Hybrid - Equity Oriented:

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Gilt Medium and LT:

Income Funds:

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Liquid Funds:

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Ultra Short Term Funds:

Short Term Funds:

Note: The returns given in the tables above are absolute up to 1 year and above one year are CAGR. NAV values are as on Dec 09, 2011. Schemes having above 1% of category corpus are taken.

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2. Turnover Ratio:

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Turnover Ratio is calculated by dividing the lower of total sales or total purchases upon its average monthly assets during a year. Turnover Ratio measures the changes in a mutual funds assets and how frequently the fund manager churns its portfolio during the period given. A higher ratio means the churning happens frequently. In a simple term, a turnover ratio of 100% implies that the fund manager has replaced his entire portfolio during the period given. Mutual Funds involve transactions of buying and selling stocks/debt paper for their portfolios. Every purchases and sales involves a brokerage cost. This brokerage cost is deducted from the net assets of the portfolios that results in a decrease in the value of the NAV. Thus, investors pay the charges for the trading that are carried out by the fund. Fund managers buy and sell frequently when the equity market witnesses more volatility. They shift to aggressive stocks when the market moves up. On the other hand, when the market goes down, they shift to defensive stocks. Hence, more of frequency of buying and selling result in higher turnover ratio. The turnover ratio hits the net returns of the mutual funds. The more a fund trades its securities, the higher its trading costs will be and this diminishes NAV. But investors should keep in mind that the schemes that have more turnover ratios are not necessarily bad if such schemes generate commensurate returns. The problem arises when a fund is trading heavily and not generating proportionate returns. On the contrary, a low ratio may sometimes imply that the fund manager is not reacting to changing market situations. This may, in turn, affect the overall performance of the fund. Turnover Ratio can give a sense of a manager's trading activity, but don't read too much into a fund's turnover rate, particularly with bond funds. In general, buy-and-hold managers will have lower turnover ratios than managers who trade on short-term factors. And generally, very high-turnover managers tend to practice aggressive strategies. With bond funds, though, quite often managers employ cash-management strategies that inflate turnover ratios.

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For Equity and Balanced Funds: The turnover ratio is more important to look while making investment decision in equity and balanced funds where the trading cost of equities is substantial. Opportunities and Dynamic equity funds have a higher turnover ratio as they move rapidly between sectors and stocks. For Index Funds: The passively managed funds such as an index funds and ETFs have a lower turnover rate compared to actively managed funds as they have to just mirror the index. The only trading here will be due to investments, redemptions and changes in the index (including the relative weights of constituents). For Debt Funds: Turnover ratio is less for income funds as brokerage costs are much lower, and hence they have a lower potential to eat into returns. So, even though gilt funds may have high turnover as compared to equity funds, the impact of this turnover on net returns is much less. Of course, the fund turnover ratio should not be the only factor for consideration when choosing a mutual fund for investment. Equally important are the funds objectives, management, historical performance, fees and expenses. Top performing high turnover ratio schemes:

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Top performing low turnover ratio schemes:

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3. Loads: Mutual funds companies charge exit loads on the investments that are redeemed or switched out before the stipulated time. AMCs are not allowed to charge entry load in investments on any schemes. But they charge an exit load to pay fees to distributors and to meet marketing expenses to a maximum of 5%. Exit loads vary among fund houses and the mutual fund categories. An average of 1% of exit load is charged from the open ended equity oriented schemes if the redemption made before one year from the date of allotment (Nil for above one year period). Exit loads on income funds vary from nil to 4% . In December 2007, the market regulator SEBI had removed entry load for open ended MFs if they were purchased directly from the fund house (not though an agent). In August 2009, it removed entry load for all MFs irrespective of the channel of sale (bought directly from the fund house or from an agent / broker).
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However, from August 2011, the SEBI allowed mutual fund distributors to charge Rs100 as transaction charge per subscription for the investment amount Rs.10,000 and above. In case the investor is investing in a mutual fund for the first time, an additional amount of Rs.50 can be charged (ie total transaction charge of Rs.150) since Know Your Customer (KYC) norms needs to be fulfilled for such new investors. This charge is applicable only on purchases and not at the time of sale. Further, if an investor purchases directly from the mutual fund company (ie online via their website or directly submitting the form in their offices), no transaction charge is levied since no distributor is involved in such cases. The charge of Rs100 per subscription for Rs10,000 and above works out to maximum 1%, irrespective of whether the investment in equity or debt funds. Hence such loads are deducted from the investments and results in the reduction in the returns from the mutual funds. Category Average of Ratios:

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Conclusion: Schemes with lower expense ratios or lower turnover ratio or lower loads are not at all necessarily better than the schemes with higher above mentioned charges. These are some of the parameters amongst many others to choose a scheme to invest. If the returns delivered by a scheme are consistently commendable, investors need not to pay more attention to these factors even if they are high. These can be useful in choosing between funds of comparable track record, size and investment strategy.

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Corporate Office: HDFC Securities Limited, I Think Techno Campus, Building B, Alpha, Office Floor 8, Near Kanjurmarg Station, Opp. Crompton Greaves, Kanjurmarg (East), Mumbai 400 042 Fax: (022) 30753435 Website: www.hdfcsec.com Disclaimer: Mutual Fund investments are subject to risk. Past performance is no guarantee for future performance. This document has been prepared by HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or made available to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein is from sources believed reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time to time positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, or other services for, any company mentioned in this document. This report is intended for Retail Clients only and not for any other category of clients, including, but not limited to, Institutional Clients.

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