Use Mutual Fund Star Ratings to understand how much you lose via commissions

Published: December 28, 2017 at 10:18 am

Last Updated on

Looks like mutual fund star ratings are useful for something after all! To understand how much you lose via commissions, study the difference between the star rating of the direct plan (no commissions) and regular plan (where commissions are removed from your investment value before NAV is reported – because what you can’t see cannot hurt you?) .

Note to the mutual fund distributor: Do not advertise my blog and direct plans by reacting to this article in social media. The best course of action for you is to ignore this article. Direct is here to stay. Venting your frustration against me will only make my stand and resolve stronger. Displaying your insecurity about direct plans will only serve to advertise it. If you still want to go ahead, make sure you mention that the content is from Stats counters cannot read emotions and I would love to have your clients as readers.

Now off to some amusing examples.

IDBI Short Term Bond Fund

Direct plan – 4 stars (VR Dec 2017)

Regular plan – 1 star

How is that possible with the same, sorry identical portfolio?

Expense ratio of the direct plan: 0.41%

Expense ratio of the regular plan: 1.59% Enough said.

If you need to still understand how this difference in expense ratios = commissions deduction can result in such a large difference in star ratings?

alpha of direct plan = 3.35 (a measure of risk-adjusted outperformance – higher the better)

alpha of regular plan = 2.39

Because of the commissions, returns are lower, risk is marginally higher and risk adjusted performance is significantly lower. Therefore lesser stars for regular plans. You can go to VR and study other metrics.

Reliance Liquid Fund – Cash Plan

Direct plan: 4 stars (Dec 2017); Expense ratio: 0.09%

Regular plan: 1 star; Expense ratio: 1.03%

Sundaram Income Plus

Direct Plan: 4 stars (VR: Dec 2017); Expense ratio: 0.41%

Regular Plan: 1 star. Expense ratio: 1.38%

List of direct plan funds that have two stars more than its regular counterpart

  1. Aditya Birla Sun Life Cash Manager – Direct Plan
  2. Aditya Birla Sun Life Short Term Opportunities Fund – Direct Plan
  3. Axis Dynamic Bond Fund – Direct Plan
  4. DSP BlackRock Short Term Fund – Direct Plan
  5. Essel Short Term Fund – Direct Plan
  6. Franklin India Government Securities Fund – Composite Plan – Direct Plan
  7. Franklin India Government Securities Fund – PF Plan – Direct Plan
  8. HSBC Income Fund – Short Term Plan – Direct Plan
  9. HSBC Ultra Short Term Bond Fund – Direct Plan
  10. ICICI Prudential Corporate Bond Fund – Direct Plan
  11. ICICI Prudential Savings Fund – Direct Plan
  12. ICICI Prudential Short Term Fund – Direct Plan
  13. IDBI Ultra Short Term Fund – Direct Plan
  14. LIC MF Liquid Fund – Direct Plan
  15. Reliance Corporate Bond Fund – Direct Plan
  16. SBI Savings Fund – Direct Plan
  17. SBI Treasury Advantage Fund – Direct Plan
  18. Sundaram Select Debt Short Term Asset Plan – Direct Plan
  19. Aditya Birla Sun Life Enhanced Arbitrage Fund – Direct Plan
  20. Axis Income Saver Fund – Direct Plan
  21. BNP Paribas Monthly Income Plan – Direct Plan
  22. Essel Income Plus Fund – Direct Plan
  23. ICICI Prudential Equity Arbitrage Fund – Direct Plan
  24. Invesco India Arbitrage Fund – Direct Plan
  25. JM Arbitrage Advantage Fund – Direct Plan
  26. UTI SPrEAD Fund – Direct Plan

List of direct plan funds that have one star more than its regular counterpart

As of dec 2017, all other funds not mentioned above.

Why is the star rating difference more (less) for some funds?

There are two aspects to this answer.

(1) Equity funds have higher commissions than debt funds. However, their returns are higher and risk is also higher. So the impact of removing commissions is not as apparent as in certain debt funds and arbitrage funds.

As an analogy, when you have loud music playing in the room, you do not hear the sound of a clock. You hear it only when there is no other noise. The presence of loud music does not mean the clock is silent. It is very much there. Just harder for you to hear. And easier for others to say that the sound is “small”.

(2) This is a subject of controversy and we have been trying to find concrete evidence about this and have not been successful. Expense ratio breakup formats used by AMCs in their annual reports are not consistent and we suspect that the actual impact of commissions is higher than that the reported expense ratio difference. We believe that this stems from the fungibility of the expense ratio

Currently, in India, the expense ratio is fungible, i.e., there is no limit on any particular type of allowed expense as long as the total expense ratio is within the  prescribed limit.

As explained here Understanding the Total Expense Ratio of a Mutual Fund and here: Mutual Fund Expense Ratio: Direct Plan vs Regular Plan, some amcs uses the same management fees (%) for both direct and regular plans and some do not. My friend’s analysis suggests that a differential management fee is more realistic.

To sum up our suspicion: We are not convinced that the direct plan expenses reported are free of commissions.

Unfortunately, this is only a suspicion. We complained to SEBI about an AMC with their annual report data and all we got was a wishy-washy unconvincing answer from the AMC. I will not name the AMC (please do not ask me in private too) and all I can do is, state that I suspect the above with no concrete proof. The reason I do so is in the hope that you start digging and do better.

However, It should be apparent to you that within the same category one fund has a 3-star difference between its direct plan and regular plans and another fund only a 2-star or 1-star difference.

On the face of it, this is due to lower expense ratio difference. Let us compare the commission’s schedules and verify this.

mutual fund brokerage structure

For example, Axis short-term bond fund has only 0.05% lower commissions than IDBI short term fund. The Axis short-term fund direct plan has only one star more than its regular plan.

Baroda Pioneer short-term fund has 0.15% higher commission structure than the IDBI short-term fund but both the BP regular and direct funds have the same number of stars(5)!! What is more, the expense ratio difference of the BP fund is much lower than that of the IDBI fund. How is this possible when the BP fund has higher commissions? These facts strengthen my suspicion.

Poor fund management = lower returns can amplify the effect of commissions. But is that alone responsible for the observed difference in star ratings? Does expense ratio accounting also play a role?

I believe so and suspect so. I can only suspect but a detailed comparison between brokerage schedules and expense ratio differences should shed more light on this.

To summarise: Higher brokerage should mean higher expense ratio of the regular plan alone. That does not seem to be the case!

Only SEBI can solve this by mandating that no part of the direct plan expense ratio should be used for commisions or gifts to distributors and by removing the above-mentioned fungibility. Better still, as I have argued in this economic times article, trail commissions should be replaced by a flat entry load like commissions. Investors should see the money going from their hands to understand the impact of commissions.

In any case, the message is clear. Your laziness is costing your dear. Get rid of your regular plans and switch to direct. Either choose funds and manage your portfolio on your own or get professional help from a fee-only financial planner

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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