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Expenses: Higher the Better?

Is a fund with a higher expense ratio always good? Is it a price for good fund management? How crucial is expense ratio in selection of a right fund?
- Shahid

Is a fund with a higher expense ratio always good? Is it a price for good fund management? How crucial is expense ratio in selection of a right fund?
- Shahid

A high expense ratio does not mean a good fund. On the contrary, an exceptionally high expense ratio in comparison to other funds in the category reflects poorly upon the fund.

A fund being good or bad has little to do with its expense ratio except for some types of debt funds. You can do a simple check to validate this. Compare the funds' ratings with their expense ratios in their respective categories. If high expense ratio were to guarantee good funds, then the top-rated funds should always be the costliest. But this is not the case and a fair amount of randomness prevails. You will not find any correlation between the funds' expenses and their performance. To assess how important an expense ratio should be to select the right fund, the right question to ask is - how materially can the expense ratio impact the returns of the fund? For example, among equity funds, the impact of expense ratio on the fund's performance will be minimal. The fund will not become a laggard or a winner just by a marginal change in its expense ratio. Therefore, long-term performance record and consistency will be far more important variables while choosing a fund. SEBI has put a tab of 2.50 per cent on the maximum expenses that can be charged by a fund, and that is good enough to keep the funds in discipline.

But the rules will change for a category like ultra short-term debt (liquid) funds. Here the returns are hard to come by and even small differences in the expense ratio of funds can make significant impact on their relative performance. Therefore, over here, expense ratio will be an important variable to watch out for. But remember, the ones with lower expense ratio should deserve preference, rather than the opposite as asked by you. For example, at present, the average expense ratio for the category of liquid funds is 0.57 per cent. Out of the 11 five- and four-star rated funds, only one has expense ratio in excess of the category average. But if we turn to the one- and two-star rated funds, as many as five out of these 11 funds have expense ratio of 1 per cent or more. Here, a higher expense ratio might have something to do with their low rating. Suppose these funds would have been charging lower expenses of 0.5 per cent then the remaining 0.5 per cent that would have been added to their returns would have made a significant impact in such a category. Therefore, expenses play an important role here.



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