Before you pick up a mutual fund for investment purpose, you do some basic research. Isn’t it? Your research may include funds past performance with respect to its benchmark and category average, its asset allocation pattern, the fund manager’s history and of course you don’t miss to look at those stars (fund ratings).

Have you ever thought of comparing one more criteria which has to be included in your research i.e. Expense Ratio of the fund. I am sure you must have. If not let me tell you this is one of the important factor that affects future fund performance if the said expense ratio is higher.

Expense Ratio is defined as the percentage of total assets that are spent to run a mutual fund. As returns from peer funds tend to be similar, expenses become an important factor while comparing funds of same portfolio. For example, if you invest Rs. 1,00,000 in a fund with an expense ratio of 1.80%, then you are paying the fund Rs 1,800 to manage your money. In other words, if a fund earns 12% with 1.80% expense ratio, it would mean you get net 10.20% return for your investment. Usually funds’ NAVs are declared net of fees and expenses; therefore, it is necessary to know how much the fund is deducting.

The expense ratio measures the per unit cost of managing a fund. It is calculated by dividing the fund’s total expenses by its assets under management. These expenses include Management Fees, Transaction Costs, Custodian Fees, and Marketing Fees etc. There are operating expenses too, such as the fee for transfer and registrar agents. They are responsible for issuing and redeeming units of the mutual fund and providing other related services, such as preparation of transfer documents and updating investor records. Other than these charges, a fee is also paid to the custodian, who buys and sells securities in large volumes. Moreover, there are legal expenses, audit fees, as well as marketing and distribution expenses.

Since these expenses in the form of Expense Ratio charged on daily basis, over the long-term it may eat into your returns massively through its cumulative effect. Fyi, the daily net asset values (NAVs) of a fund scheme are reported after deducting such expenses, though the expense ratio is disclosed only once every six months.

Any entry load (currently entry load has been removed) or exit load might be onetime cost incurred when one enters or exits a fund, and are charged as a percentage of investment/encashment amount. So if your fund’s returns are high then these load might not impact a lot, but what if any cost/expenses are getting deducted on daily basis out of the NAV and you get an expense adjusted NAV every time.

For eg; Rs. 1,00,000 over 10 years at the rate of 15% will grow to Rs. 3,10,585. But if we consider an expense ratio of 1.80%, your actual total returns would be Rs. 2,64,129, nearly 18% less than what would have been achieved without any expense charge.

Now let us understand the long term cumulative impacts of such expense ratios with the below scenario.

Say, fund ABC Top 100, PQR Top 100 and XYZ Top 100 has got similar portfolio holdings and they are expected to generate 12% pa returns for the next 5/10/15/20/25 and 30 years. But the only difference between these funds are, they have different expense ratios such as;

Even though the above fund’s annual expected returns seems to be same, but they have got different expense ratios. Eventually these expense ratios are going to impact the long term fund’s returns in a big ways.

Let’s say, you invest Rs. 1,00,000 each into these 3 funds and left for the next 30 years. Now you can see the differences in fund values year on year till the end of the 30 years.

Excessively high costs can eat into returns and can lead to an opportunity loss over the long run. The first step to getting it right is to understand exactly what it costs to run your investments and then to make them as simple and transparent as possible. But a lower expense ratio does not necessarily mean that it is a better-managed fund. A good fund is one that delivers good return with minimal expenses.

On January 1, 2013 all mutual fund houses rolled out a new plan under all of their existing products — the Direct Plan. In these options investor can directly investment with the AMCs without routing their investment through brokers. The main difference between the Direct Plan and the Regular Plan (existing plan) is the expense ratio which is lower in case of direct plan compare to regular plan, because the fund houses are required to incur higher expenditures to third party distributors with the above list of marketing, transaction, custodian and operating cost. Thus with direct investment option investors will get the NAVs with lower cost.

In my future article I am going bring the detailed differences between Regular Plan and New Direct Plan of investment into Mutual Funds, and the ways to safe switch from Regular Plan to Direct Plan if required. So stay tuned!

Hope this article made you to think once to look into the funds expense ratio before finalising it for investment. Do share your views or ask your queries.

How higher Expense Ratios eat into your MF’s future growth

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