Why is expense ratio important?

We have all heard of the well-known saying in economics – “there is no free lunch in this world”. Essentially, for any service that you get, there is a cost, visible or invisible that you end up paying. Even in investing, be it trading in stocks or investing through mutual funds, you do have a cost to pay for the opportunity to grow your money. In the case of mutual funds, just look for the Total Expense Ratio (TER) to know the underlying cost that you end up paying for investing through them.

What is the Total Expense Ratio (TER)?

Total Expense Ratio or TER is the total operating cost that a mutual fund management spends annually, expressed as a percentage of the AUM or the Assets Under Management. Most mutual funds deduct the amount daily from the AUM.

For instance, suppose there is a mutual fund with Rs. 1 Crore in Assets Under management with a Total Expense Ratio of 2%. On day 1, if the NAV opens at Rs. 10 and the fund has made a return of 1% in the day. Then, on Day 2, the NAV will move up by the final amount of returns after deducting the daily expense ratio. In this case, the fund has made a return of 1% or Rs. 1,00,000 whereas the cost is (2%/365) on the AUM of Rs. 1 Crore which comes to approximately Rs. 548. So, the AUM will move up to Rs. 1,00,99,452 and the NAV will move up to Rs. 10.099452 by the time the NAV opens on Day 2.

In India, SEBI monitors the TER that various fund houses charge on different funds like a hawk. In fact, it has mandated that fund houses can only charge in the range of 1.34% to 2.25%, in multiple bands on the basis of the fund AUM. Higher the AUM, lower the TER that they can charge considering the absolute figures are much more at that level. 

Why is it important?

You might be wondering that why should TER be such a big deal when it’s only in small percentage numbers. How can it make an impact with a few percentage points here or there? There are two main reasons why Total Expense Ratio should be an important parameter when you choose a mutual fund to invest in.

Impacts profitability

One of the first things, most of us look at when it comes to mutual funds is the returns. Every mutual fund shows returns post deducting the Total Expense Ratio. Higher the TER, higher the impact on probability of returns and the profitability that the fund can generate. So, even if the mutual fund manager is delivering great returns but the fund has higher operating expenses, the two factors might end up playing against each other.

Erosion on compounding

The reason we invest in mutual funds is so that we can lock up that money in for a few years and let it grow through the magic route of compounding. However, it is over a longer term that Total Expense Ratio ends up making the most difference. When you choose a mutual fund with higher TER, each and every day, a bigger chunk is deducted as a part of expenses, not allowing those little chunks to grow with time. 

Difference between Direct and Regular Expense ratios

As regular readers might know, today there are two kinds of plans for the same mutual fund that investors can opt for – Direct and Regular. In the Regular plans, the Total Expense Ratio is higher since the costs include commissions paid out to brokers and other distributors. On the other hand, the Direct plans are much lower, allowing investors to save anywhere from 0.8%-1.2% in TER annually.

Over time, this difference can amount to much bigger difference than the miniscule difference you see here. Let’s look at an illustration for more clarity. 

Illustration

Suppose you are investing in a SIP of Rs. 10,000 every month for ten years. You could have either invested in the Regular Plan of Fund X or the Direct Plan of Fund X. Let’s assume that there is a 1% difference in the Total Expense Ratio of the two plans. Accordingly, if the Regular plan gave an average return of 14% in the ten years that you were invested, we can assume that the Direct plan gave an average return of 15% over the same ten year period.

So, you end up investing the same amount of Rs. 12,00,000 over a ten year period. However, while the funds would have grown to Rs. 24,92,923 in the Regular Plan, with the same investment in Direct plan the funds would have grown to Rs. 26,30,182. When you look at absolute returns, your money would have grown at 108% in the period in a Regular Plan and 119% in the Direct Plan. 

As you can see, over time Total Expense Ratio ends up making a substantial difference to your investments. 

Now that you know all about Total Expense Ratio, make sure you make it a big part of your decision making process when you invest in Mutual Funds.