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Wednesday, October 1, 2014

How important is a Mutual Fund expense ratio?

 

How important is a Mutual Fund expense ratio?

 

Boost your long-term portfolio return by paying attention to the cost of the mutual funds you invest in.

In developed markets such as the US, investors pay a lot of attention to the cost of mutual funds. It is time you too turned more cost conscious while selecting funds.

Penny pinching pays

Paying attention to a fund's cost is important because a high expense ratio reduces your returns. The money that would have gone into your pockets goes to the fund house if the expense ratio is high.

A high expense ratio also affects a fund's performance. The fund house that has pioneered the low-cost investment approach in India, cites an example. If a fund has an expense ratio of 2.5%, it means that the fund manager has to outperform the benchmark by 2.5 percentage points just to be at par with it. The higher the expense ratio, the bigger the level of outperformance required of the fund manager. Thus, a low expense ratio acts as a tailwind for fund performance. Quantum's own funds, with an expense ratio of 1.25% (for its large-cap equity fund and ELSS fund), consistently enjoy high ratings and are testimony to the advantage of a low expense ratio.

While funds' returns vary from year to-year, their fee remains constant. Every fund will have years when it gives low returns. In those, a high expense ratio takes away a substantial portion of returns. And when the return is negative, a high expense ratio drags down returns even lower.

Over the long term, even a small difference in cost can make a considerable difference to the size of your retirement corpus. To give a hypothetical exam ple, suppose that you invest Rs 1 lakh each in two funds with gross return of 15% each.

One of them gives a net return of 14% (expense ratio 1%) while the other gives a net return of 13% (expense ratio 2%). Over 30 years, the corpus in these funds will be Rs 50,95,015 and Rs 39,11,589 respectively--a difference of almost Rs 12 lakh.

Applying the principle of thrift

Experts say that the weightage you give to expense ratio while choosing a fund should depend on the product category.

Active funds: In case of these funds, expense ratio should not be the most important criterion. f active fund management results in a higher net return to investors consistently, then expense ratio should not be the most important consideration. As the Indian market becomes more efficient, it may become difficult for fund managers to create alpha consistently. Then India too may go the US way, where investors prefer passive funds and give a lot of importance to the cost of funds.

In case of active funds, apart from expense ratio, investors should pay attention to the fund management team's experience level, consistency in investment approach, the processes followed by the fund house, the AMC's track record, and the fund's performance.

Passive funds:

Expense ratio assumes greater significance in the selection of passive funds. Since returns of passive funds belonging to the same category are quite similar, the expense ratio can make a significant difference to performance. However, blindly choosing the lowest-cost index fund may not be in your interest. If a fund's expense ratio is low and the corpus size too is small, the fund house will make very little money. There is a risk that it may close down the fund or neglect it. Investors should look for funds with a record of low tracking error and low cost.

Debt funds: In this category, too, you should give a lot of weight to expense ratio. The absolute returns that debt funds can generate are lower compared to equity funds, hence you don't want to give away a high percentage of those returns in fees. Even in case of debt funds you should pay attention to the kind of market in which past returns were obtained (high or low interest rate environment), the fund management team's experience level, and the processes followed by it.

Direct plans of funds: You can now save on fee and enhance your long-term returns considerably by investing in direct plans. The differences in the expense ratios of regular and direct plans within the same category are considerable. For do-it-yourself investors who know which asset classes and products to invest in, and who can manage their portfolios themselves, direct plans are a good option.

Finally, always bear in mind the long term impact of a high expense ratio on returns and try to select good funds from the low-cost ones

For further information contact Prajna Capital on 94 8300 8300 by leaving a missed call

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