New Delhi. While investing in mutual funds, we often pay attention to things like returns, NAV, fund category or risk profile, but one small line sometimes completely changes the game of your total profits – Expense Ratio. This is the charge, if ignored, investors can lose not just thousands but even lakhs of rupees in returns over several years. The interesting thing is that the expense ratio may seem small, but due to compounding, its impact becomes very big in the long run.
What is expense ratio?
In simple language, expense ratio is the fee that the mutual fund company (AMC) charges for managing your money. This fee includes many expenses like salary of the fund manager, expenses of the research team, transaction cost, administration, marketing and other costs related to running the fund. If the expense ratio of a fund is 1%, it means that 1% of the total amount of your investment will be deducted every year. The amount is automatically reduced from the NAV, so the investor does not have to make any separate payment, that is, no matter how good your returns appear, some part of them is actually reduced due to this charge.
Active Fund Vs Passive Fund, where charges more?
Active funds usually have high expense ratios (1%–2% or even higher). The expense ratio of passive funds usually ranges between 0.10%–0.50%. This is why low-cost passive funds have become increasingly popular in recent years.
How do diminishing returns occur? Let us understand in a small example
Suppose you invested Rs 10 lakh in a fund which gives 12% annual return. Now let us compare two funds, one of which has an expense ratio of 1%, the other 2%. Due to just 1% extra fee, the investor gets about ₹ 2.5 lakh less. If this investment continues for 20–25 years, then the difference can increase from lakhs to several lakhs or even crores.
This charge is not fixed, it can change every year
Expense ratio is not permanent. It may increase or decrease if the AUM of the fund increases or market related rules change. SEBI has set limits to ensure that companies do not charge arbitrary charges.
Direct Plan Vs Regular Plan, the big difference is hidden here
Most investors unknowingly invest in regular plans, which have a higher expense ratio.
- Regular Plan: Expense Ratio + Distributor Commission
- Direct Plan: Expense ratio only (no commission)
For example, the regular plan of a fund charges an expense ratio of 1.9%, while the direct plan charges only 1%. In the long term, even this small difference can reduce your fund by lakhs of rupees.
Investors can easily check expense ratio at these 4 places
- Mutual fund factsheet
- AMC official website
- SEBI/AMFI website
- mutual fund apps
Always keep 2 things in mind while comparing funds
- Is the expense ratio of your fund higher than the average for that category?
- Can switching to a direct plan save you money?
The whole science of distorting returns
The most dangerous effect of expense ratio is its chronicity. It is harvested every year.
This causes two things – your return base gets reduced. The power of compounding becomes weak. The lesser the charges, the greater will be the growth of your money. This is the reason why SEBI and AMFI continuously advise investors to choose options with lower fees.
How to reduce expense ratio?
- Choose direct plan instead of regular.
- Look at passive/index funds,
- Always compare AMC and fund on the basis of expense ratio.
- Keep reviewing the fund from time to time.
