How can expense ratio affect your mutual fund returns?

If you have done even a simple research on mutual funds or invested in them, you would have heard about something called expense ratio. And you probably have some idea about what it means and how it can affect your mutual fund returns and portfolio.
Before we understand the impact of expense ratio on your portfolio, let us understand what expense ratio means.

 

How expense ratio can affect your mutual fund returns?

What is expense ratio?

Expense ratio is the amount which is payable to the (mutual) fund house. This is expressed in terms of ratio (to assets under management). It is the fees which investors pay to the fund house for managing their money. This money is used for expenses like fund manager & team’s fees, marketing, agent commission and other administrative costs.
So, if you invest Rs. 10,000 in a mutual fund which has an expense ratio of 2%, you will be paying Rs. 200 to the company for managing the remaining Rs. 9800 on your behalf, trying to invest it in best possible avenues.
(Disclaimer – This Rs. 200 won’t be deducted right at the beginning. Have put it simplistically for ease of explanation)
For a fund house with an AUM (assets Under Management) of Rs. 10,000 Crore and 2% expense ratio, this number will be Rs. 200 Crore. Typically, for a larger AUM, the expense ratio should be lower. (As lot of costs don’t increase proportionately with increase in AUM)

How does expense ratio impact your mutual fund returns?

Expense ratio is charged annually. So, in the above case, you pay 2% of your assets with the fund house every year for managing it.
Suppose your investment of Rs. 10,000 generates a 10% return in 1 year. With 2% expense ratio, your effective returns will be 7.8%. (as the investment value would have grown to Rs. 11,000 and 2% of that is Rs. 220. So your net returns is Rs. 780).
In long run, you end up paying this 2% every year, with an objective of getting professional expertise. Nothing wrong in that, as many of us lack time and/or skills to track individual stocks or other investment options) over a long term
Expense ratio is applicable to all kinds of mutual funds – equity funds, debt funds, liquid funds etc. Different types of funds may have different expense ratio. Usually the funds that are more actively managed have an higher expense ratio & the funds that are not very actively managed (e.g. Exchange Traded Fund – ETF, or liquid funds) have a lower expense ratio.
In India, SEBI (Securities & Exchange Board of India) regulations limit the total expense ratio of mutual fund to 2.25% of AUM (Assets Under Management).
There are more rules & fine print. You can read them here.

Should expense ratio be important in choosing mutual fund?

The difference between say, a 1% expense ratio and 2% expense ratio may not seem significant over short term. But in long run it can make a significant difference. You keep on paying that year on year, till the time you are invested. That being said, the variability in returns provided by mutual funds can be higher. Awareness of this can have impact on your expected returns while investing.
So, theoretically, if two fund houses offer same returns, then the one with lower expense ratio is better. But how do we predict? We can’t. Unless there is some kind of superpower!
My answer to this question is-
We can’t predict what the difference of the returns between two mutual funds (including index funds) be. And past performance is not an indicator of future performance. We can just play a guessing game!
While one can choose fund house with lower expense ratio, it is no guarantee or indicator of better returns.
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Lot of us are aware about something called expense ratio, but we rarely give a thought about its implication on our portfolio. Maybe, we just treat it as a necessary evil. Maybe, we are right!

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