Every business involves costs and charges that are typically transferred to the end user. There are no free lunches and investing has costs associated too. When you invest in mutual funds, the asset management company (AMC) charges you a fee to manage the funds. This fee, which is a percentage of the capital invested, is called total expense ratio (TER).
What is Expense Ratio?
It is a levy that the fund house charges investors for managing their funds. It includes operating, marketing and administrative expenses and fund handling fees.
An interesting feature of the expenses related with mutual funds is that these are completely regulated by Securities Exchange Board of India (SEBI). Thus, no AMC can levy any charges which are outside the purview of those prescribed by SEBI. This information is displayed on the websites of the AMC and the Association of Mutual Funds in India (AMFI) and widely available in the public domain too. It is calculated based on the total assets of the fund.
Expense Ratio = Total expenses
Total assets under management of the fund
For example, if the total expense of a fund amounts to INR 5 lakh and the assets under management (AUM) of the fund is INR 8 crore, the expense ratio is 0.63%. It means that out of the total assets, 0.63 % will be charged as fees for managing the scheme.
The calculated ratio indicates the per-unit cost incurred for managing the funds.
Is Expense Ratio Same For All Funds?
The expense ratio of funds is different for every asset class. Equity schemes have higher ratios than debt schemes and liquid schemes. Moreover, as the size of the fund increases the expense ratio percentage keeps on dropping. The ratios are capped by the prescribed limits as per SEBI and as the AUM increases, the percentage drops.
SEBI has permitted additional limits that can be charged by fund houses on each category of funds. Thus the expense ratio is within a range as shown below in table 1.
Table 1: Category-wise expense ratio
How Does It Impact an Investor’s Returns?
The expense ratio indicates how much the AMC charges annually. However, this amount is subtracted from the returns of the scheme before they are distributed. Thus, the net asset value (NAV) of the scheme is adjusted for the expenses on a daily basis.
Very often, investors compare the performance of unit-linked insurance plans (ULIPs) and mutual funds. This is like comparing apples and oranges because in the case of ULIPs, the expenses are deducted by reducing the number of units held by the investor whereas in the case of mutual funds, they are adjusted in the NAV.
What Does Higher Costs Mean?
Generally, the lower the AUM of the fund, the higher will be the expense ratio. However, going only by the expense ratio is like comparing the costs of different models of mobile phones manufactured by different companies. Ideally, apart from the price, you should compare all the other features of the product and you may find yourself willing to pay a higher price for a superior product.
Even within the same category, the expense ratios differ because of the difference in AUMs. For example, the expense ratio of two mid cap schemes is different as seen below. Axis midcap scheme has a higher AUM and low ratio and Quant scheme has a low AUM and the expense ratio is high.
Table 2: Higher AUM lower expense ratio
Similarly, a higher expense ratio does not mean higher returns, as seen in table 3 below. Among the equity schemes tabled, Kotak Bluechip Fund has a higher expense ratio but low returns as compared to Canara Robeco Bluechip Fund.
However, schemes with a low ratio can also have low returns, as seen below. Therefore checking returns and the ratio together to select schemes is not a good indicator. Scheme selection must be done prudently by checking its quantitative parameters.
Table 3: Equity returns post expense ratio deduction
This is just for illustrative purposes; if you look at the expense ratio and if you decide only on that basis it could result in a different actual return. So, it’s best to avoid deciding on where to invest merely based on a comparison of the expense ratios.
Are Expense Ratios Relevant For Investors?
In the past, investments were done through a distributor channel so only regular plans were available. Later, SEBI permitted investors to invest directly in funds through AMCs. That’s when direct plans came into existence and slowly a disparity of expense ratios emerged.
As mentioned earlier, expenses are deducted from the returns of a scheme. However, if you observe closely, the deduction of an equity scheme’s expense ratio from its returns does not make a huge dent.
The difference between direct plans and regular plans can best be understood by drawing an analogy to online shopping versus purchasing from the store. For the same product it was found that online prices were much lower than those in the regular store.
The expense ratio of regular plans is higher than that on direct plans as there is a distributor commission involved in the case of the former. There has been a debate on whether an investor should opt for direct plans or regular plans and the jury has a hung vote.
There are many fintech portals that now provide you with access to mutual funds through direct plans. In fact as an investor it is very important to know your preferences and capabilities; if you are financially savvy you can go ahead with direct plans.
However, if you find that you need advice then do not hesitate to take the assistance of a financial advisor. An investor comes to the equity markets to earn superior returns compared to other asset classes. So if you are comfortable engaging a financial advisor, at the cost of a 0.5% to 1% lower return per annum you can go ahead with an advisor, else you can always try the “do it yourself” method.
For debt schemes, expense ratios do matter as the returns are range bound. If a scheme has a higher expense ratio then the returns will be less. For example, consider three corporate bond funds, as seen in table 4 below. The returns of the scheme are range bound and become lower in the case of the higher expense ratios.
Table 4: Debt fund returns post expense ratio deduction
Again, the above is only for illustration purposes. However, for debt schemes, one should not rely on the expense ratio alone while choosing a scheme. You should check the credit quality portion of the portfolio. Choose a scheme that has a higher allocation towards AAA and AA credit rated papers. Any scheme with a higher allocation to below AA rated papers could indicate higher risks.
Therefore, relying on the expense ratio as a parameter could be misleading, and one should focus more on other parameters, specifically for equity oriented funds.
There is a lot of noise around the expense ratios charged by mutual funds and some outcry about why one should pay fees to a distributor. In my opinion, mutual funds have played a very significant role in channelising investors’ funds into the capital market and investors have been able to create wealth over a long period.
By introducing direct plans, SEBI has also ensured that the distributors/advisors are vigilant and provide value added services to the investors, else there are a plethora of options available to investors. One thing which all investors need to be clear about is that there is “no free lunch” and if anyone offers free services, there is likely to be a catch.
Thus, while investing in mutual funds you must ascertain what suits you best. Are you comfortable doing everything on your own or do you need to seek guidance to understand the nuances of investing. If you are clear about what you are looking for and decide to take the help of a distributor, then paying a slightly higher expense ratio shouldn’t be a problem when you select a regular plan.
Bottom Line
All schemes of all AMCs have expense ratios and how these impact the returns you would earn matter. But it is not the only deciding criteria while selecting a suitable scheme. A high expense ratio or low expense ratio does not necessarily suggest that a scheme is good. A good fund has a low expense ratio provided it delivers good returns.
Thus, before investing in a fund, ensure that you pay attention to various aspects of the scheme, irrespective of the plan (direct or regular) and choose as per your requirements.
