Importance of expense ratio in mutual fund investment
While past performance is often the first consideration when investors choose a mutual fund, it's important to remember that it's not a guarantee of future returns. A crucial factor that often gets overlooked is the expense ratio, which can directly impact your returns
Lower expense ratios translate to higher potential returns for investors. This is because the net of all costs, including fund management fees, distributor costs, and promotional expenses, is reflected in the NAV (Net Asset Value). A higher expense ratio can significantly reduce your final return
When we choose a mutual fund (MF), the foremost parameter often considered by the investors is the performance. Despite knowing that the past performance is not a guarantee of future returns, most investors tend to make judgement based on that. Also, seasoned long-term investors know that the top of the table in terms of performance never remains constant, still many fall for this.
The fund objective defines the overall philosophy, the past performance when looked into phases, provides an understanding on how the fund performed at various intervals of the market. It could be estimated from the risk ratios like sharpe ratio, Treynor’s ratio and Sortino ratio. Another important aspect most investors ignore or unaware is the cost of the fund i.e., fund management costs.
This is similar to a fee one pays for availing a professional help like that of a chartered accountant or lawyer, etc. Similarly, fund managers who manage the fund also charge a fee to maintain and manage the investment in a fund. This is simply known as the expense ratio in a fund. This includes the fund management fees, the distributor costs, promotional expenses and other expenses (as approved by the market regulator, SEBI).
An expense ratio could directly impact your returns as the net of all the costs is what’s reflected in the NAV (Net Asset Value) of a fund. So, higher the expense ratio, the lower possibilities of returns. For instance, if an investment of Rs. 1lakh has earned 15 per cent for ten years then the fund value would be Rs. 4lakhs at the end of the period. But, if we deduct an expense ratio of 1.5 per cent per annum, then the fund value would be Rs. 3.5lakh only. That is about 12.5 per cent lower than the actual value.
Of course, all the funds one invests in India, the calculation is implicitly done and the final NAV includes all these costs and is derived. So, one wouldn’t know the actual costs explicitly but would provide you the cost of return. The cost one pays to generate returns. Hence, it’s always better to find funds with lower expense ratio so that one could end up giving higher possibility of compounding their investment.
However, most actively managed funds have relatively higher costs than passive funds. An active fund is where the fund manager takes investment decisions based on the fund objective while a passive fund operates completely without any human intervention, mostly tagged to an index. The returns are dependent upon the index performance and its composition, the latter isn’t decided by the fund manager. Generating alpha i.e., higher return than the benchmark is not possible, as this investment hugs the benchmark albeit with a tracking error.
To be noted also is that not all funds have same expense ratio. Generally, the expense ratio is higher in those funds where the fund manager activity is higher or necessary. Part of the expenses arises due to the churn or activity in the fund. Most actively managed equity funds have expense ratios up to 2.25 per cent. That is the extreme limit allowed to be charged by the Securities Exchange Board of India, SEBI and it can’t exceed 2 per cent in a debt fund. The expense ratios are provided and clearly mentioned for each fund as prescribed by the regulator. All the disclosures of the fund i.e., in all the material print, online or in any of the communication about the fund contains this information. So, investors could check and compare across the funds within the same category to identify a lower charging fund while having a better past performance.
Other than investing in passive funds, investors could explore the direct option of the funds. The direct option is different from that of the regular fund where in the latter, the distribution costs i.e., commission is added to the fund, charged from the investor. Direct funds are not a completely different category but the same funds which are invested directly with the Asset Management Company (AMC) without any distributor or middlemen. The AMCs or fund houses pass on the distribution costs or discount that cost while calculating the NAV so that one could find the NAV is always higher for a direct fund over a regular one on any given date.
Direct option, while saves costs, is suitable for those investors who could assess which fund to opt and are capable of managing their own funds. Distributors are not just middlemen but are qualified and appointed by the regulator to help pick funds for the investor, also service the investors. Nonetheless, one should keep in mind that lower expenses doesn’t translate into higher returns for the investor and so a fund delivering good returns at minimal cost is an ideal choice.
(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])
