Why expense ratio is significant while investing in mutual funds?

Being a mutual fund investor, it is important to know the various aspects which can impact the returns of your investment. The expense ratio is one of those aspects which carries a lot of importance as it is one of the basic things which directly impacts the returns.

The expense ratio is the fees levied by AMC’s each year. It is per cent of net asset which is incurred by the AMC’s for day to day management and buying and selling of securities. The expense ratio ranges between 0.5 to 2.5 per cent , generally.

For actively managed equity funds, the total expense ratio (TER) allowed as per the SEBI (Mutual Fund) Regulations 1996, is 2.5 per cent for the first Rs. 100 crore of average weekly net assets; 2.25 per cent for the following Rs. 300 crore , 2 per cent for the subsequent Rs. 300 crore and 1.75 per cent for the balance asset under management. Similarly, for the debt funds, the expense ratio allowed is 0.25 per cent lower than that of equity funds. Information regarding the expense ratio for a MF scheme is stated in the Scheme Information Document. Moreover, mutual funds have been permitted to charge up to 30 bps that is 0.3 per cent more expenses, if 30 per cent or more of new inflows come from locations Beyond the Top-15 (B15) cities.

But these expenses may eat your returns up to 50%. Is it possible? The answer is yes, let’s look at an example. Mr. A is investing Rs. 1,20,000 in a mutual fund scheme for 30 years. Assuming the consistent performance of the scheme lets assume average annualised gain at 10 per cent per annum. At the end of 30 per cent where he will end up?

With this, we can see that Mr. A in a fund with an expense ratio of 0.5 per cent invested Rs. 1,20,000, after 30 years he will get Rs. 18,08,393 and will pay Rs. 2,85,536 as an expense which forms around 14 per cent of his total investment value. In the same manner in the funds with the expense ratio of 2 per cent and 2.5 per cent he will pay around Rs. 11,42,143 and Rs. 14,27,678 as expenses which form around 55 per cent and 68 per cent , respectively.

This clearly implicates why expense ratio is significant, higher expense ratio can lead to lower returns. Higher expense ratio can eat your returns up 65-68 per cent directly in a longer run. So an investor should always consider expense ratio while selecting the mutual fund scheme.