Mutual funds’ outsourcing Slashing Expenses, easing fee
Anitha Dilipan

The mutual funds industry is a common and reliable investment in India. But with the investors becoming conversant about the fees and expenses charged by them, it is in a grave position to find out ways of cutting those expenses. And as with other industries, it has been engulfed by the outsourcing wave to curb costs.

No service is a free lunch. And this applies to the Mutual fund industry too. Now a days, the investors have known to interpret a mutual fund prospectus better than what they used to previously. They now have understood that while looking into the offerings by the MFs- besides looking at the fund's track record, latest performance and the credit worthiness of the Fund managers and so on, one has to look into the fund expenses too. Not to know the cost efficiency of the fund but directly to know how much he should have earned before the expenses.

Investors many a times believe that a costly fund performs well. This may be compared to the halo effect wherein the investors get into the perceptual error of going in for products with a high expense ratio (ER) believing that a high ER would ensure consistent and good performance of the fund. But there are records that prove that this is not a holy writ.

According to Lipper , there is an inverse relationship between the mutual fund costs and the return to the shareholders. The report which covers a period of 1998-2002, states that the Elfun Money Market fund which is the lowest in rank in the Average ER (Expense Ratio) scores the highest rank in the Net Average Annual Return. According to Vanguard, while 94% of the funds earned gross returns ranging from 4.90% to 4.60%, the top decile funds earned a net return of around 4.43%, while the bottom decile funds earned 2.93%. The expense ratios of the top decile averaged to around 0.37% and that for the bottom decile averaged to 1.74%. Hence it cannot be inferred that the top performing funds should have high ERs.

In the Indian scenario itself, we have the Franklin India Bluechip Fund, one of the top-performing equity funds, has generated an annual return of 27 per cent over the past five years and charges an expense ratio of 2 per cent when compared to the JM Equity Fund with a 9 per cent annual return over the same period, has an expense ratio of 2.5 per cent. Hence this perception may not always be correct.

Factually speaking it is the other way round. The funds as their asset base increases operate on economies of scale and hence the costs are reduced as a part of cost-efficiency.

Analysis of Expenses

[1] Lipper, a Reuters company, is a global leader in supplying mutual fund information, analytical tools, and commentary.

[2] www.vanguard.com,“Exhibit 2: Money Market Fund Gross Returns, Expense Ratios, and Net Returns; 1998 – 2002”

[3] Aarati Krishnan, 20^th June 2004, “Why expenses can make or break returns?”,The Hindu Business Line.

The expenses of a mutual fund may be classified as follows:
 

(*An asterisk indicates fee is included in a fund’s expense ratio.)
Source: Article by Mr. David Harrell in Morning Star.com

The major chunk of any mutual fund goes to the management fee.  The management fee has two components viz. Performance Fee and Group Fee.  The performance fee is based on the performance of the fund and will go up or down with the performance level.  The group fee is calculated as a percentage of the overall assets the fund company that is represented by the fund.  Administrative fee is a normal fee, which is paid for the administrative activities of the fund.  The brokerage cost is an expense that is not included in the expense ratio. It is shown separately in the annual report either as a percentage or as the full dollar value itself.  The interest costs, which are incurred if the fund borrows money to buy securities, are also represented in a similar way.  These expenses are already accounted for in the fund’s return.

There are some expenses that are not already accounted for in the fund’s return.  These are more of sales related fees also referred to as Loads.  The loads are traditionally the compensation received by the brokers for the advice.  It is deducted at source.  That is, the investment less the percentage of load is what is actually invested.  These loads are of two types- front end and back end.  Front end is applied on purchase and the back end load is applied when the investment is sold.

Redemption/Transaction fee is yet another expense which is encountered by the investor, but the difference is that these fees directly go to the fund itself rather than to the fund company.  This is levied to avoid the market timers as the sudden inflows and outflows of cash put the manager in a cryptic situation to buy and sell securities in an unplanned manner.  Account maintenance fee is usually charged on small accounts.

The investors would not pay attention to the expenses ratio as long as the, the fund is doing well.  Once they come to know that the fund is slipping, they seem to worry about the expenses ratio.

There are many factors that decide the return of the shareholders.  Though the market indicators have a very important role to play, they are not in the control of the fund in specific.  There are so many forces that rule the performance of the fund.  One factor that is under the control of the fund is cost reduction.  Today’s buzzword of outsourcing is directly related to the phrase of cost-reduction.  The trend today in mutual funds is also to outsource certain non-core activities to Low Cost Countries (LCC) and benefit by the cost leverage and in turn increase the return to the shareholders.

Vanguard makes a money market comparison, which proves that the larger the asset base, the ER becomes lower.

Source: www.vanguard.com

The above table shows that in the case of Smith Barney Funds, 68% of the expenses comprises of the management fee, while in the case of Vanguard, it is only 8%.  Major chunk of the expenses in the case of Vanguard is from the shareholder services which are only 13% in the case of Smith Barney funds.  In the case of a performing fund, the expenses are high but start falling down once the economies of scale are achieved.  It is evident from the above that with a total asset base which is more than Smith Barney, Vanguard is operating at lower costs.

So, funds like Vanguard, which is spending more on the shareholder services, can even reduce that cost by riding the outsourcing wave.  The shareholder services may include contact centers, reports prepared for the unit holders, account maintenance etc.

To explain the value chain in the case of outsourcing in a mutual fund industry per se, the first phase is that the provider offers only non-core and non-critical activities which are called Generic services in the Outsourcing language for a single company.  This is a basic stage wherein the client experiments by outsourcing its back office operation like maintaining records of the shareholders (which are termed as transfer agency services), custodian, contact centers for the shareholders, HR services, Reconciliations, etc.

In the second phase, there is a value addition to the service offered to the client in the first phase.  The client looks in for information services along with the generic service provided.  Information services include collecting, sorting, editing of data and collating the information pertinent to the industries and stocks for which the provider may gather input from Bloomberg or Reuters or other Information data bases.  The information services may relate to a particular sector or a specific industry as per the requirements of the client.

In the third phase, the provider widens his clientele by globalizing and thus entering into multiple geographies and multiple companies.  Thus the provider no longer focuses on the single anchor customer as in the first and second phase.

The fourth phase is an interesting phase wherein the provider using the expertise that he gained in the previous three phases goes a step further and looks in for investment advisory services, recommendation in stocks and so on.  The role is similar to that of the Asset management company otherwise termed as the fund manager who is responsible for making decisions related to any portfolio of investments (often a mutual fund, pension fund, or insurance fund), in accordance with the stated goals of the fund.  This is a very critical activity as the fate of the fund is decided on this basis.  This is the stage where-the client manages his portfolio based on the advisory services given by the provider.

The role of a fund manager is so crucial that in some funds, investors see the fund manager as a brand for the fund.  There have been cases where the exit of a fund manager has led to unimaginable redemptions.

The fourth phase differs from the basic idea of outsourcing that is the cost reduction.  This phase is a combination of the real pool of talent with the global market knowledge and thereby attaining the unparalleled quality of service at a lower cost.  But then, these days it is mostly the IT+BPO companies, like Datamatics Software, that are into providing basic services for the mutual funds. Unless, functional expertise is infused into the field wherein asset management companies get into the fray, reaching the fourth phase would be a far cry.

Conclusion

In today’s outsourcing world, the Indian providers are probably in the first, second and third phases.  Even the Equity Research which is outsourced is not a fourth phase activity as it is only a consulting service and the fund is not bound to go by the advice offered.  It is different from the services offered by a fund manager wherein the fund manager is wholly responsible for deciding the portfolio.  It is a long way to reach the fourth phase, as it requires a lot of expertise not only in the domain knowledge, but also a global insight.  What might suit one market might backfire in the other.  

To outsource an activity of that critical nature, the client needs to have that level of confidence in the service provider.  The client needs to be convinced that the provider, who has all along been meeting the performance metrics for the current processes outsourced, can add value to the service and provide a key role in the fund management also.  Tomorrow is definitely there are Indian would no longer remain a destination for low-end activities alone.  There are many fourth phase activities in the pipeline. It is only how we specialize in what we say and how we project ourselves we know matters.

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