Case 068Scheme design and product strategyCore

Setubandh Mutual Fund plans a mid cap index fund and an ETF at a 0.25% expense ratio, with fixed costs of Rs 1.5 crore a year for data, index licensing and operations. What AUM does it need to break even, and should the index fund or the ETF launch first?

The situation

Setubandh Mutual Fund, a mid-sized fund house, wants a mid cap passive range. It can launch an index fund, bought and sold through the AMC and distribution platforms, and an ETF on the same index, traded on the exchange. Both would charge an expense ratio of 0.25%. For simplicity, assume the AMC keeps all of it.

Each product needs about Rs 1.5 crore a year of fixed costs: index data and licence fees, fund accounting, the passive team's time and exchange charges. Running both together would cost about Rs 2.0 crore, because the licence and team are shared. The distribution team expects the index fund to gather about Rs 15 crore a month through SIPs and platforms. The ETF has no anchor investor yet; without one, the team expects about Rs 8 crore a month.

Your task

What AUM does each product need to break even, how long would it take, and which should launch first?

Quick check

At a 0.25% expense ratio, what fund size covers Rs 1.5 crore of fixed costs?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Each product needs about Rs 600 crore to cover Rs 1.5 crore of fixed costs at 0.25%. Launch the index fund first. At Rs 15 crore a month it reaches breakeven in about 40 months, and SIP flows build steadily. An ETF without an anchor would take about 75 months and would trade at wide spreads while small, which deters buyers. Launch the ETF when an institution commits enough money to give it scale from day one.

Step 1Why is breakeven so high for a cheap product?

A toll road charging Rs 5 a car needs far more traffic to pay for its maintenance than one charging Rs 50. At 0.25%, every Rs 1 of fixed cost needs Rs 400 of assets, so Rs 1.5 crore needs Rs 600 crore. Passive products are cheap for investors precisely because they spread fixed costs over a lot of money, which makes them scale businesses: below scale they lose money every month, above it each extra rupee is almost pure margin.

A passive fund pays its fixed costs only once it is big enough0.51.01.52.02.5Breakeven: Rs 600 croreFixed costs: data, index licence, operations, Rs 1.5 croreFees at 0.25%loss zonefees cover costs02004006008001,000Fund size, Rs crore; Rs crore a year on the vertical axis
At a 0.25% expense ratio Setubandh's fee revenue rises Rs 0.25 crore for every Rs 100 crore of assets and only covers Rs 1.5 crore of fixed costs once the fund reaches Rs 600 crore, so everything below that size runs at a loss.
Step 2How long does each product take to get there?

Run the months. The index fund, gathering Rs 15 crore a month, reaches Rs 600 crore in 40 months, and its cumulative loss before fees catch up is about Rs 2.44 crore. The ETF, gathering Rs 8 crore a month with no anchor, takes 75 months and loses about Rs 4.62 crore on the way. The difference is not the fee or the cost; it is how fast money arrives. Market growth would help both, so treat these as conservative.

Launch pathMonths to Rs 600 croreCumulative loss before breakeven, Rs crore
Index fund, Rs 15 crore a month402.44
ETF, no anchor, Rs 8 crore a month754.62
ETF with a Rs 400 crore anchor, then Rs 8 crore a month250.50
Setubandh's index fund reaches breakeven in 40 months at Rs 15 crore a month, an ETF without an anchor would take 75 months, and an ETF seeded with Rs 400 crore by an institution would take 25 months with a much smaller loss on the way.
Step 3Why does the ETF struggle more when it is small?

An ETF has a second hurdle the index fund does not: it must trade well on the exchange. A small ETF has few trades, so market makers quote wide spreads, and buyers who see a wide spread stay away. A small ETF looks illiquid, and looking illiquid keeps it small. The index fund avoids this entirely: investors buy at NAV through the AMC, and SIPs bring money in every month whatever the exchange screen shows. That is the case for launching the index fund first.

Step 4What would flip the order?

An anchor. If a provident fund, an insurer or a large wealth platform commits Rs 400 crore to the ETF, it starts near scale, market makers quote tighter spreads, and breakeven arrives in 25 months. Institutions often prefer ETFs because they can trade in size during the day. Launching both together also helps the economics: shared fixed costs of Rs 2.0 crore need combined assets of only Rs 800 crore, so the second product rides on the first. The recommendation: launch the index fund now, keep the ETF filed and ready, and list it the day an anchor commits. Fixed costs and flows here are illustrative; the AMC's real costs and any expense ratio limits should be checked.

Where candidates lose it

Candidates divide the wrong way, 0.25% times Rs 1.5 crore, or forget to annualise, and get a breakeven far too small. Rs 1.5 crore of yearly cost against a 0.25% yearly fee is Rs 600 crore of assets.

The other miss is treating the two products as identical because their cost and fee are identical. The ETF's liquidity problem at small size, and its reliance on institutional buyers, is the real reason to sequence the launches.

What the interviewer asks next

  • What expense ratio would bring the index fund's breakeven down to Rs 400 crore, and what would that do to its competitiveness?
  • A rival launches the same index at 0.15%. How does that change the plan?
  • How would you measure whether the ETF is trading well once it lists?

Company names and figures are illustrative.