The dark truth about the expense ratio in your mutual funds

Investors generally look at the performance of the funds when investing in to mutual funds, ignoring the dark truth about expense ratios, which can greatly impact the returns over a longer period of time.  Investors generally lack the understanding of expense ratios and fail to understand how the returns from the mutual funds can get greatly reduced due to a high expense ratio.

This article will help the investors to know how returns from a fund with a low expense ratio can give better returns compared with the funds having a high expense ratio.

But before starting our quest let us first understand what expense ratio is all about. 

What is expense ratio?

Investing into the mutual funds is very easy compared with other asset classes. They are managed by professional fund managers who allocate and manage your money in volatile market situations. For providing this service, the fund houses charge certain fees on an annual basis which is captured as an expense ratio.

The expense ratio is what you have to pay the fund house on a yearly basis. This charge is deducted from the value of the mutual fund. It takes into account all the expenses that the fund incurs, including management fee, administration and transaction costs, and marketing. Expense ratios typically range from 0.3% to 2.5%. The lower the expense ratio, the better it is for you, because you pay less.

Expense ratio is charged from your investments made in mutual funds on a daily basis before NAV is declared.

NAV is the price at which investor buys or sells units of Mutual Fund. It is derived by dividing the total assets (sum of total value of all securities and cash) of the fund by the number of units issued to investors. The value of your investment is driven not only by NAV but, it is a product of NAV and number of units.

To make it clearer, let me guide you through an example; suppose an investor has invested INR 100,000 in a fund whose expense ratio is at 1%. Let us assume that the mutual fund grew by 10% in a year, which turns out to be INR 10,000. 

It is quite natural for the investor to think that his/her investment value has increased to 110,000, but that is not the case. The fund house will deduct the expense ratio first before publishing the actual returns. Let us now see, how much the investor has to pay as expense ratio and what will be his/her total gain. 

10% percent increase of the amount will mean 100000+ 100000*10/100= 110000. Now we have to pay 1% expense ratio on the amount. So this 1% is computed as follows 110000- 110000*1/100+ 1100.

So, the final value of the investment would be 110000-1100=108900 which is 8.9% increase and not 10%.

By now, some of the investors have actually started to calculate how the expense ratio will reduce the return of their hard earned money over the years, while another set of investors must be thinking that it doesn’t matter to pay high expense ratios as long as they get decent returns from their mutual fund holdings.

If the investor is investing for a time horizon of one to two years, then expense ratio shouldn’t be a major cause of concern for them, but if the investor is investing for a longer time frame then certainly it is bound to have a major impact on their returns.

Impact of Expense Ratio

Let us now see how the expense ratio can impact the mutual fund returns over a longer time frame.

For the sake of simplicity we have taken three scenarios with three different expense ratios; 1%, 1.5% and 2%. We will calculate the three different scenarios and see how a lumpsum investment of INR 200,000 lacs will return after 25 years taking into consideration that will return at an average rate of 10% every year.

Time Period (Year)	1% Expense Ratio	1.5% Expense Ratio	2%  Expense Ratio
1	200000	200000	200000
2	217800	216700	215600
3	237184	234794	232416
4	258293	254399	250546
5	281281	275642	270088
6	306315	298658	291154
7	333577	323596	313864
8	363266	350616	338346
9	395597	379892	364736
10	430805	411613	393186
11	469146	445983	423856
12	510900	483223	456916
13	556371	523572	492556
14	605888	567290	530974
15	659812	614659	572390
16	718535	665983	617036
17	782458	721592	665165
18	852126	781845	717048
19	927965	847130	772978
20	1010554	917865	833270
21	1100493	994507	898266
22	1198437	1077548	968330
23	1305098	1167523	1043860
24	1421252	1265012	1125282
25	1547743	1370640	1213054
		-177102	-334692
		-11.44%	-21.62%

Table 1: Showing long term returns with various Expense Ratios

This simple example shows you that how a fund with higher expense ratio can lower down the returns in the long run.

In a longer term, you can see how the corpus value reached more than 15 lacs with 1% expense ratio, but if the expense ratio was 2%, then despite the same performance, the corpus would be only reach to 12.1 lacs. That’s approximately 21.62% short from the fund which has 1% expense ratio. 

This will clearly act as an eye opener for investors that a fund with high expense ratio can erode your returns, so one must take this important factor in to consideration before investing in a mutual fund.

In the case of debt funds, the impact of expense ratio is even more. Debt funds generally generate 8-9% average returns so it will hurt to pay 2% expense ratio for 8-9% average return for debt funds.

Scheme Name	Date	Expense Ratio
AIG India Equity-Reg(G)	31-Mar-2012	2.4100
Axis Equity Fund(G)	31-May-2012	2.5000
Axis Midcap(G)	31-May-2012	2.5000
Baroda Pioneer PSU Equity(G)	31-Mar-2012	2.5000
Birla SL Equity(G)	31-Mar-2012	2.1500
BNP Paribas Equity Fund(G)	31-May-2012	2.4500
DWS Alpha Equity(G)	30-Apr-2012	2.5000
Edelweiss Equity Enhancer-B(G)	31-May-2012	2.4600
Fidelity Equity(G)	31-Mar-2012	1.8400
HDFC Top 200(G)	31-Mar-2012	1.7700
HSBC Midcap Equity(G)	31-Mar-2012	2.4600
IDFC Equity-A(G)	31-Mar-2012	2.3000
Reliance Equity-Ret(G)	31-Mar-2012	2.0200
My Recommended Funds (Large Cap)
DSPBR Top 100 Equity-Reg(G)	30-Apr-2012	1.8400
ICICI Pru Focused Blue Chip Equity-Ret(G)	31-Mar-2012	1.8300
Franklin India Bluechip(G)	31-May-2012	1.8200
Source : ACE MF

Table 2: Showing the performance of different equity funds

As evident from the above table, my recommended large cap funds have the least expense ratio when compared with the expense ratios of few of the stalwart funds in the industry. Please note the above fund list comprises of all equity funds which include large, multi and mid cap funds.

Conclusion

A fund with high expense ratio will lower the returns in the long run. So when an investor is choosing two similar performing funds, they should look at their cost structure.

The dark truth of expense ratio discussed in this article will give investors a holistic view while comparing similar mutual funds with almost equal returns. So a fund which delivers superior risk-adjusted returns and has lower expense ratio is a better bet for your portfolio.