Big Questions

How does expense ratio affect returns?

Let's understand if and how expense ratios can lower the value of your investment returns

How does expense ratio affect returns?

What is an expense ratio?
An expense ratio is a fee that you (investors) pay to mutual fund companies to manage your money. It includes charges such as fund management fees, agent commission, selling and promotional expenses, among others. Learn more about expense ratio.

An expense ratio can range anywhere between 0.5 to 2.50 per cent for an equity fund. It may not seem huge, but it can significantly eat your returns in the long run. A 1.5 per cent expense ratio can wipe out nearly 40 per cent of your investment returns. An expense ratio higher by even 1 per cent can wipe out nearly 30 per cent of your total investment returns.

Now, that's a huge dent in your overall returns.

What should you do?
Go for a fund that has a lower expense ratio.

But is a lower expense ratio enough in choosing a fund? Not really; a fund should be a consistent compounder first. This means a fund should be consistently rewarding over a long period.

Let's understand with an example

There are two funds, A and B. Fund A gives a return of 10 per cent pa and charges 1 per cent as a fee. Fund B gives a return of 12 per cent pa and charges 1.5 per cent as a fee. Now, if you plan to invest Rs 10 lakh with a horizon of 40 years, fund A would return a value of Rs 4.50 crore, whereas fund B would return Rs 5.42 crore. Clearly, B returned about 20 per cent more than A.

This proves that expense ratio is not the only metric one must consider before choosing a fund. The fund must also consistently deliver returns.

Go for direct plan of mutual funds
The easiest and the best way to not let expense ratio kill your returns is to go for the direct plan of a mutual fund. Direct plans have a lower expense ratio than regular plans of funds. However, even if the fees between these two plans may not look substantial in percentage terms, the impact on the overall corpus becomes meaningful over a period of time, as from the example above.

If you are capable of managing your investments and don't need any hand-holding with selecting or managing a fund, then you can easily go for a direct plan. You will significantly lower your expense ratio and receive slightly higher returns over time.

Key takeaways

  • Check the expense ratio before investing in a mutual fund.
  • A lower expense ratio does not make the fund the best. A fund that delivers good returns with minimal expenses is the way to go.
  • If you're a DIY (do-it-yourself) investor, direct plan is the easiest way to reduce your expense ratio.

Suggested read: How to invest in direct plans of mutual funds

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