Expenses: The silent killer!
March 3, 2004
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Here’s a question for mutual fund investors. “What parameters do you study in a mutual fund scheme before making an investment decision?” The most likely answers will be the scheme’s returns vis-à-vis its peers, the asset management company, the fund manager and his investment style. Some discerning investors might go a step further and inspect the scheme’s standard deviation and sharpe ratio as well. There is another “much-ignored” factor which finds place in the fund’s offer document - “expense ratio”.
The fund’s expenses broadly cover the investment management and advisory fee, the marketing and selling expenses etc. Put simply the expense ratio denotes the amount out of the total corpus which is being used to finance the scheme’s expenses. What makes the expense ratio really important is that it ‘eats’ into the investors’ returns i.e. if a fund is high on such these expenses, it is left with a lower amount to distribute amongst investors. A good enough reason for investors to closely monitor it!
Let’s not jump to a conclusion that a fund with a lower expense ratio is better than a fund with a higher expense ratio. The expense ratio is one amongst a host of factors which decide a fund’s attractiveness. What a lower expense ratio does instead is it gives you a better chance of raking in higher returns. For example if you were to invest Rs 20,000 in two funds each, Fund A with a lower expense ratio (1.5%) and the other, say Fund B with a higher expense ratio (2.0%). Assuming that both the funds maintain a consistent 12% growth rate per annum, at the end of 10 years the lower expense fund would have raked in Rs 11,000 more than the other fund, i.e. you would have recovered more than half of your invested amount.
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Low expenses…Higher returns!
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| Year end |
Fund A |
Fund B |
A - B (Rs.) |
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20,000 |
20,000 |
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| 1 |
22,064 |
21,952 |
112 |
| 2 |
24,341 |
24,095 |
246 |
| 3 |
26,853 |
26,446 |
407 |
| 4 |
29,624 |
29,027 |
597 |
| 5 |
32,681 |
31,860 |
821 |
| 6 |
36,054 |
34,970 |
1,084 |
| 7 |
39,775 |
38,383 |
1,392 |
| 8 |
43,880 |
42,129 |
1,751 |
| 9 |
48,408 |
46,241 |
2,167 |
| 10 |
53,404 |
50,754 |
2,650 |
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Total |
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11,227 |
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A word of caution. The comparison for expense ratios must be between funds from the same asset class i.e. comparisons between a diversified equity fund and an income fund would not present the true picture. Similarly index funds traditionally display the lowest expense ratios since the fund manager has a mandate to purely replicate the chosen index.
Mutual funds at times charge entry and/or exit loads. These loads imply further erosion of investors’ returns. While the impact of loads is visible upfront, fund’s expenses are like silent killers. They are reported in the offer document, fund’s accounts statements and rarely catch the investor’s eye. As a result the necessity to monitor them closely is further magnified.
Having said all this, investor’s should remember that the expense ratio is one amongst various factors to be studied. If investors are faced with a situation wherein they have to choose between two schemes with similar characteristics, then the expense ratio could be the right factor to base your decision upon rather than the toss of a coin.
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