The expense ratio, or the fee charged by the asset management company(AMC) to manage money, is often ignored. Why should investors consider it while selecting a fund? Because it is deducted from the returns generated by a fund. Even a small difference in the expense ratio between two funds with similar gross returns can make a huge difference to returns in the long run. Let us look how.
For managing a fund, AMC incurs a recurring cost which includes fund management fees, transaction cost, registrar and custodian fees, selling and distribution cost among others. All these add up to the expense ratio, which is calculated as a percentage of the fund’s average net asset value (NAV) and is available in the fund’s monthly fact sheet.
The fund’s NAV, which is disclosed on a daily basis, is calculated after deducting the expense ratio.
Small can make a big difference
Giving due consideration to the expense ratio while selecting a fund can make a big difference to your portfolio in the long term. This can be construed from the hypothetical case study detailed below.
An investor wants to invest Rs 10,000 per month for 25 years in funds A, B or C. Assuming these funds generate the same 15% gross returns, but charge different expense ratios of 2%, 1.5% and 1.25%, respectively, net returns from these funds turn out be 13.00%, 13.50% and 13.75%, respectively. If an investor chooses fund C (the lowest expense ratio among all), it would help him/her generate additional Rs 33 lakh and Rs 11 lakh compared with funds B and A, respectively, just because it charges a lower expense ratio (50 bps and 75 bps vis-à-vis funds B and A, respectively). Hence, even a small reduction in the expense ratio can create sizeable difference in the long term. Mutual funds also offer the direct plan option to investors who want to reduce the expense ratio by not paying the distribution fees. Unlike in a regular plan, where investors purchase mutual funds from distributor channels, investors in a direct plan can purchase directly from the AMC thereby
saving costs related to distribution.