Importance of Expense Ratio while selecting Investments

The common retail investor is getting more and more price sensitive while selecting their investments. This is definitely a good thing, given the background of extremely high charges packaged into traditional financial products. However, this frenzy to reduce charges needs to be approached with caution. By focusing only on cutting down the cost of investment management or advice, we might end up compromising the quality of the same.

We breakdown the impact of charges on your returns and explain what is reasonable and what is not. These charges are usually represented in the form of expense ratio for each fund. Let us understand what expense ratio is.

What is expense ratio?

The expense ratio, also called management expense ratio or total expense ratio (TER), refers to the percentage of funds assets that are used for all operating expenses of the fund. These include charges like management fees, administrative cost, distribution expenses, etc.

For example: 

  • Fund A has assets under management of Rs 10,00,00,000
  • Fund A is charging Rs 20,00,000 for all its operating expenses
  • This would amount to a TER of 2% {(20,00,000 / 10,00,00,000) x 100}
expense ratio

What is the impact of expense ratio on my returns?

Generally Mutual fund (MF) expense ratios range somewhere between 0.75% – 1.5%. An expense ratio of 2% – 2.5% or more is considered high. There are solutions such as exchange traded funds (ETFs) with expense ratios around 0.2% – 0.5% (since they are not actively managed)

Let us compare an investment of Rs 10,00,000 at a 10% annual rate of return for the purpose of these projections:

  • A high cost MF with a TER of 2.5%
  • A nominal cost MF with a TER of 1%
  • A low cost ETF with a TER of 0.3%
mutual funds versus ETF
importance of expense ratio

As is clear from the above projections, a lower expense ratio directly translates to higher returns. This gets more pronounced as we look at longer time horizons due to the compounding effect. A difference of 1.5% in TER between the high cost and nominal cost MF leads to a difference of Rs 40,28,038 in returns over a 30 year period. Similarly the 0.7% difference in TER between the nominal cost MF and the low cost ETF leads to a difference of Rs 24,83,033 over a 30 year period.

What are the other considerations?

The impact of expense ratio on the returns are substantial enough to make it an important consideration in the decision making process while selecting MFs or ETFs. However, there are other factors that impact the returns which might be ignored if we solely fixate on the cost. It is important to take note of these in order to arrive at the final decision. Some of the key ones are as follows:

Fund historical returns

Let’s say we were to choose between the following investment options:

  • India Technology MF (TER 1%) – 10 year annualised returns of 11.3% before charges
  • India Technology ETF (TER 0.3%) – 10 year annualised returns of 9.8% before charges

The 30 year returns for the MF above will be Rs 1,71,66,820 while the return for the ETF will be Rs 1,38,99,829. The returns from the MF are higher than the ETF in spite of the higher charges. Hence, the impact of the actual performance of the MF or ETF is equally important when selecting the appropriate investment vehicle.

Comparing the MF or ETF with the benchmark for similar funds or indexes is a good strategy to gauge the relative performance. That would help you compare whether or not the fund is outperforming the benchmark in the sector.

Portfolio optimisation strategies

Beyond looking at the expense ratio and fund’s historical returns, the entry, exit and optimisation strategies into your portfolio are critical in determining your overall returns. Imagine a lump sum investment is made right before a financial market crash, it could take years to recoup the loss in value of investments. Hence, having an understanding and knowledge about time tested investment strategies like dollar cost averaging and automated fund rebalancing will reduce risks within your portfolio and safeguard returns.

portfolio optimisation strategies

Bottom Line

The expense ratio is one of the most important factors while selecting a MF or ETF. However, there are other factors like fund performance, investment advice, portfolio management and optimisation that affect long term returns and need to be taken into account as well. 

A good balance of all the above factors is required to maximise your returns. This is where it is important to ensure you have the necessary knowledge and expertise at your disposal to weigh the various factors and guide your investment portfolio decisions. Working with an adept investment advisor or robo advisor can make a huge difference in determining long term returns.

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