Are low-cost funds best options available out there?

According to the study carried out by Vanguard, low-cost funds tend to perform better than those bearing the high cost. Now, you might be thinking as to how does cost matter while investing? 

Why cost matter? 

Though the cost while investing seems to be no big deal, the costs add up in a similar manner to how your returns compound. The problem is not with the small amount that you lose in the form of the expense ratio that you pay, but it is about the growth that you lose for that extra penny you pay. Suppose the expense ratio of Fund A is 0.5 per cent and that of Fund B is a mere 0.1 per cent, though the difference of 0.4 per cent seems to be low, you are losing all the growth that you might have had for years into the future by investing those 0.4 per cent. 

Say, for instance, you have invested Rs 1 lakh in a fund that earns 10 per cent a year for the next 25 years and had no expense ratio, you will end up having close to Rs 10.83 lakh. 

Now, say, if you had to pay 1 per cent a year in costs, post 25 years, you would have only accumulated about Rs 8.43 lakh. 

Yes, you read that right! A mere 1 per cent you paid every year would wipe out almost 22 per cent of your accumulated value. So, now, one per cent might not sound small right? 

However, the question is whether does it make sense to select funds solely based on the expense ratio? We shall find out by carrying out a study by comparing the returns of funds with a lower expense ratio with that of funds carrying a higher expense ratio. In order to do this, we would be simply analysing the expense ratio and three-year trailing returns of all the equity funds. 

In the above table, we have listed three-year trailing returns of the funds with the lowest as well as highest total expense ratio (TER). If we see, there seems to be no such positive correlation between the expense ratio and the performance of the funds. For instance, Quant Consumption Fund and Quant Infrastructure Fund performed better than the top five funds with the lowest TER despite having one of the highest TERs. 

Further, we carried on two rankings wherein first, we ranked funds based on three-year rolling returns and secondly, we ranked funds based on their TER. Lowest TER gets a higher rank while the highest returns get the highest rank. 

The above two tables clearly show that there is no correlation between the lower expense ratio and the highest returns. As we can see, those funds ranked on the basis of three-year trailing returns having expense ratios higher than that of those funds that are ranked based on TER. 

Therefore, investing in funds just because its TER is low, makes no sense at all. Researching and investing in good funds is not a piece of cake. Hence, we would recommend investors take a holistic view before investing in mutual funds.