I have invested in diversified equity funds like HDFC Top 200, Reliance Growth and DSPML Opportunities. When I compared these funds against one another, I found that they differ in terms of the expense ratio and also in risk grade. What does expense ratio mean? If all of these funds charge the same sales load, why is there a difference in risk grade?
It is good to know that you have been doing research on your investments and asking pertinent questions. Though there is no relation between the expense ratio, the risk grade and the sales load, all the three variables play an important role in making our investment decision. Let's look at each of the three concepts separately.
Expense ratio is the percentage of your investment that you pay a fund every year for managing your money. Like a doctor who charges you for his service, mutual funds too charge a fee for managing your money. This involves the fund management fee, agent commissions, registrar fees, and selling and promoting expenses. All this falls under a single basket called expense ratio. Since this is charged every year, a high expense ratio over the long-term may eat into your returns massively because of the power of compounding. Thus, lower the expenses, better it is for you. Among the three funds in question DSPML Opportunities has the lowest expense ratio of 2.24 per cent and Reliance Growth has the highest at 2.5 per cent. However, expenses play a greater role in debt funds, as the returns are lower compared to equity funds.
The risk grade captures a fund's risk of losing your investment. The risk of investing in a mutual fund not only includes the possibility of losing money, but also the chance of earning less than you would have on a guaranteed investment. That's what we cover under 'Risk Grade'. We measure risk by taking the fund's return for each month since it was launched and comparing it with monthly returns from a risk-free investment. Risk-free investments are those that are backed by the government, or similar to such investments. A low risk grade and high return grade is the best combination for any mutual fund. Thus, the risk grade should be looked at in conjunction with the return grade.
DSPML Opportunities and HDFC Top 200 are four-star funds and Reliance Growth is a five star fund as on December 31, 2003, but all bear different risk grades. In your case, HDFC Top 200 bears a below average risk grade. This is because of its large investment universe—the stocks of BSE 200. The fund tries to consistently beat this index and the weights are controlled based on the weights in the BSE 200. With this approach, the fund has stayed largely diversified with individual stock exposure largely staying within limits of prudence.
On the other hand, DSPML Opportunities bears above average risk grade because of its aggressive investment mandate. The focus of the scheme is to respond to the dynamically changing Indian economy by moving its investments across different sectors, such as pharmaceutical, cyclical and technology depending upon the prevailing trend. This also means that the chance of the fund's strategy going wrong is high here. Thus, DSPML Opportunities Fund falls in the above average risk grade.
Reliance Growth has a reputation of tasting new stocks and digesting them rather quickly. This means that it hardly stays with its picks for long. Despite this, the fund has been able to deliver top-notch returns in recent times. The fund has been assigned an average risk grade due to its relatively lower downside risk among the diversified equity funds.
However, risk grade has nothing to do with the sales load. Sales load is charged to investors in order to pay for the distributor's sales expenses. Here, all three funds charge an entry load of 2 per cent. Now you will have a better idea as to what makes a fund less or more risky compared to others.