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Why every mutual fund investor should care about expense Ratio?

expense-Img1Expense Ratio includes fund management fees, marketing or selling expenses, transaction costs, Investor communication costs, custodian fees and register fees. Expenses Ratio is calculated as a percentage of the fund’s average Net Asset Value(NAV). The daily NAV that is published is after deducting the expense ratio.

For an actively Managed fund, SEBI imposed certain limits on expense ratio(Below table has the summary for equity funds). For debt funds, the expense ratio allowed is 0.25 percent points lower than equity funds. Service tax on fund management charges is also passed on to the investors, which adds to the expense Ratio.

Corpus(AUM)Cost as % of AUM
First ₹100 Cr2.5%
Next ₹300 Cr2,25%
Next ₹300 Cr2 %
Balance Corpus1.75%

Why is it important?

For Most of the mutual funds expense ratio is between 2 and 3%, which may not be high if the funds are delivering 25 to 30 percent returns, but when the funds return comes down to single digit or low double-digit, this expense ratio will hurt as it becomes a quarter of your return :( , if you consider compounding over long-term, this can have a cascading effect.

In the above chart, you can see what a difference of 1% can make over a period of 20 or 30 years. If you invest in two funds with a monthly SIP of 10K each, with 1.5% and 2.5% expense ratio, assuming both funds return give around 15% CAGR, you end up with  1.25Cr more in the fund with 1% less expense Ratio, which is not a paltry sum even considering Inflation over 30 year period :-)

Should it be the only criteria in choosing a mutual fund?

No. A fund with excellent track record charging 2.5% might be better than the fund with average track record charging 1.5%, choosing the later over earlier one might save some money, but if you consider Compounding benefits and the long-term opportunity cost, earlier choice might work better.

Is there an alternative?

Global investors are migrating to index funds, which are not actively managed, but comprises of mainly index stocks and expense ratios are significantly less, compared to actively manged mutual funds, this might happen in India too over a time period.

Expense Ratio is in addition to the exit load charged by mutual funds(only if you exit before certain period of time, 12 to 24 months), entry loads are banned by SEBI.

Happy investing!