A number of parameters are to be considered before investing in a mutual fund. One of them is Expense Ratio – it is the percentage of a mutual fund’s total net asset/corpus that goes towards meeting recurring operating costs. Different operating cost incurred by mutual funds include management costs, legal and audit fees, marketing and selling expenses and other miscellaneous charges.
In Indian context, as per SEBI regulations equity and debt funds can charge a maximum expense ratio of 2.5% and 2.25% respectively. This is in addition to one-time costs like entry/exit load. On an average, most equity funds have expense ratio between 1.5% and 2%. In case of index funds, it could be lower, in the range of 1-1 .5%.The expense ratio is disclosed by fund houses once every six months.
Key points:
- Expense Ratio is a key parameter to be considered while choosing a mutual fund. While a figure of 2.5 looks innocuous, a small difference in expense ratio makes a huge difference in the long term. We will see that in the example below.
- Especially, in case of debt funds where rate of return is on the lower end (8-10 % per annum), the impact of expense ratio becomes more evident.
- Index funds and exchange traded funds (ETF) have lower expense ratio as they are passively managed and saves on the steep operational cost of active funds.
- While expense ratio is a key parameter, it is however not the only consideration while choosing a mutual fund for investment.
Let us consider two hypothetical funds A and B which has expense ratios of 2.25% and 1.75% respectively. Suppose a sum of 3 lakhs is invested in these two funds for a time framework of 10 years and each of these funds return an annual return of 15%.
As shown in the table above, a difference of 0.5% in expense ratio has a considerable impact on the maturity value of the two funds to the tune of 50K.
Assumption made
- Expense ratios and annual rate of return (RoR) remain constant for both the two fund throughout the timeframe, though in practice it varies.
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