Majority of the investors don’t know why expense ratio in Mutual Funds matters because expense ratio is one of the least discussed topics. Little do we know, it plays a critical role in giving you good returns. People do not even check or analyze the expense ratio before investing in any mutual fund thinking that 1% or 2% won’t matter that much.
To be honest, even I had no idea on how much impact it can create in long term when I started investing. Hence I’m going to give you an important piece of information here.
Nothing comes for free, we all know it. Mutual funds aren’t free either because the Asset Management Companies (AMC who manages these mutual funds) aren’t doing any charity. There can various ways where the AMCs can spend this money. For example advertising, salary of managers and staff, transaction costs for buying, selling shares, etc.
This fee charged to Mutual Fund investors is called expense ratio.
Let’s say if your Mutual Fund has an asset under management (AUM) worth of Rs.100 crore. They take Rs.2 crore in a year for managing it. We can say this fund has an expense ratio of 2%. However, this 2% will not be taken on a single day. It will be divided into the number of working days in a year.
Hence a very small portion of your investment will be taken daily which you will not even realize. For an example, it will be 2% divided by 365 days which is 0.005% per day. Hence if you invest Rs.10,000, then Rs.0.5 will be taken daily as expense fee as per 2% of the plan.
So we can say expense ratio is the percentage of the fund’s assets that is used up in managing and operating the fund.
WHY IS IT SO IMPORTANT?
A higher expense ratio has the power to damage your returns. It may not make much difference in short term though.
No one can predict what the fund can give you in future. You can definitely look at the past returns. However, a top fund of last 10 years may become the worse in next 10 years, you never know. This had happened in the past in many cases. Hence, all you have at present is the Expense ratio in front of you which is a fact. Rest all are predictions.
To see how fund cost can affect your investments over time, let’s compare the returns of several hypothetical investments that differ only in expense ratio. The following table depicts the returns on a $10,000 initial investment, assuming an average annual return of 10%, with different expense ratios (0.5%, 1%, 1.5%, 2%, and 2.5%):
Hence, even a small difference in expense ratio can cost you a lot of money in the long run. If you had invested $10,000 in the fund with a 2.5% expense ratio, the value of your fund would be $46,022 after 20 years. Had you instead invested your $10,000 in the fund with a lower expense ratio i.e. 0.5%, your investment would be worth $61,159, a whopping 32.9% improvement over the more expensive fund.
Conclusion: If you’re confused between two Mutual Funds with similar portfolio & returns then go for the one which has lesser expense ratio or the one with a strong track record.