Fund Advice. How important is the expense ratio?

Picking up your fund’s latest fact sheet, you notice that the expense ratio is 2.1 per cent. Is that good or bad? Can the expense ratio significantly impact returns? Here’s the answer.

Expense ratio is the cost incurred to operate a fund. It is the amount you pay a fund — a portion of your invested money — every year to manage your money. Expenses include the costs of selling and buying stocks, fund management fee, agent commissions, registrar fees, and selling and promotional expenses.

While different funds have different expense ratios, the SEBIhas capped the amount that funds can charge based on the type of fund. Equity funds can charge a maximum of 2.5 per cent whereas a debt fund can charge 2.25 per cent of the average weekly net assets.

Since this charge is made on the total assets of the scheme, your fund NAV is calculated after deducting this charge.

But when do you really need to take note of the expense ratio? Well, it depends on the type of fund you invest in.

Expense ratios for equity funds on an average vary between 2.2 and 2.5 per cent. Considering equity funds that have delivered more than 20 per cent in the last 10 years, a one percentage point change in expense ratio does not make a material difference.

In actively managed equity funds, expense ratio is secondary. Funds follow different strategies and have different levels of portfolio churn which, in turn, impact returns.

Besides, equity has the potential to deliver blockbuster returns which can more than compensate for higher expenses in management.

Take, for instance, large-cap equity funds over the last five years. The top funds — such as HDFC Equity, ICICI Pru Focussed Bluechip or Franklin India Prima Plus — all have among the lowest expense ratios of 2.2-2.3 per cent.

But Birla Sun Life Top 100, whose expense ratio is 2.8 per cent, also ranks at the top. So your aim is to select a consistent, good performing fund instead of worrying about where it ranks on the expense ratio front. If you’re considering two funds with similar strategy and performance, use the expense ratio as a differentiator.

Expense ratio makes a notable difference in debt fund returns as these funds do not generate the high returns equity funds do.

For instance, after delivering close to 14-15 per cent returns annually, gilt funds took a knock last year. Returns on gilt funds are down to single digits in the last one year. With a long-term expected return of 8-9 per cent on such funds, expense ratios make a huge difference. A fund with a 1.2 per cent expense ratio will be much higher than one with 2.2 per cent ratio.

Among the top performing gilt funds — L&T Gilt Fund, IDFC G-Sec and Tata Gilt Mid Term that have delivered 7-8 per cent annually in the last five years — expense ratios vary from 1.3 per cent to 1.8 per cent.

However, for funds with mediocre returns, a high expense ratio can be an added dampener. For instance, LIC Nomura G-Sec, which has underperformed other funds in the category, also sports one of the highest expense ratios of 2.3 per cent.

Similarly, for passive funds, such as index funds, keep an eye on the expense ratio. Since they simply mimic an index’s returns, the expense ratio will help zero in on the best funds.