What Is Expense Ratio? This Hidden Cost In Your Mutual Fund Matters More Than You Think
The expense ratio in mutual funds, often overlooked, impacts long-term returns. It covers operational costs and varies by Assets Under Management. Lower ratios yield better net returns.
In the world of mutual fund investing, many investors focus on the fund’s portfolio, past performance, and the reputation of the asset management company (AMC) behind it. However, a crucial factor that often gets overlooked is the expense ratio. If you have been neglecting this detail, it’s time to rethink your approach. The expense ratio, while seemingly small, can significantly impact the long-term returns on your investments.
The Concept of Expense Ratio
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Think of services like Netflix or Swiggy, where a fee is charged to access the service. The fee is necessary to cover the operational costs involved in delivering the service to customers. Similarly, when you invest in a mutual fund, you are essentially paying for the services provided by the AMC. This fee is known as the Total Expense Ratio (TER).
The expense ratio includes the costs incurred by the AMC to manage the fund, pay the fund manager, custodian, trustee, and brokers, as well as administrative expenses such as distribution, marketing, and advertising. It represents the annual charge levied on the investment to cover these operational costs.
Expense Ratios Vary Across Funds
It’s important to note that the expense ratio can differ even between two funds that appear to be similar. The underlying reason for this lies in the different operational structures of various AMCs. Several factors influence the expense ratio, with the most significant being the Assets Under Management (AUM) of the fund.
Generally, a fund with a larger AUM can afford to charge a lower expense ratio, as it has more capital to manage. In contrast, funds with lower AUM tend to have a higher expense ratio. The maximum permissible expense ratio for smaller funds is typically 2.25%, while for larger funds, it can be as low as 1.5%.
How the Expense Ratio Impacts Your Returns
The expense ratio plays a crucial role in determining the actual returns on your investments. While it might seem like a minor detail, over time, high expense ratios can erode your wealth significantly.
Suppose you invest Rs 1 lakh in a mutual fund with an expense ratio of 1.5%. This means that every year, Rs 1,500 will be deducted from your investment as part of the operational fees, regardless of whether the fund performs well or not.
Now, imagine you are investing Rs 10,000 each month via Systematic Investment Plan (SIP) in two funds over a period of 10 years. Fund A has an expense ratio of 1% while Fund B has an expense ratio of 2%. Both funds provide an average return of 13%.
After accounting for the expense ratios, Fund A will offer a net return of 12% annually, while Fund B’s return will be reduced to 11%. Over the 10-year period, your total investment in both funds will amount to Rs 12 lakh. However, due to the higher expense ratio, Fund B’s total value after 10 years will be lower.
In Fund A, the total value of your SIP investment will be Rs 23.23 lakh, yielding a return of Rs 11.23 lakh. In comparison, Fund B will only grow to Rs 21.89 lakh, providing a return of Rs 9.89 lakh. This means that the difference in returns between the two funds would be Rs 1.33 lakh, a significant amount over a decade.
It’s essential to debunk the myth that higher expense ratios automatically lead to better returns. In reality, the size of the fund and how it is managed play a much more significant role in the fund’s performance. According to Arjun Guha Thakurta, Executive Director at Anand Rathi Wealth Limited, a higher expense ratio does not necessarily correlate with better fund management or higher returns.
In fact, with experienced fund managers at the helm, even a fund with a lower expense ratio can generate excellent returns. The key takeaway is that while the expense ratio is an important factor to consider, it should not be the sole determinant in choosing a fund. It is crucial to evaluate the overall performance, the fund manager’s track record, and the AMC’s reputation before making a decision.
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