Why Expense Ratio Matters When You Invest in Mutual Funds

Would you buy inferior quality products at discounted prices? Or pay a very high price for a product even when a cheaper substitute is available?

Obviously not, right?

When it comes to mutual fund investing, we believe you should adopt a similar approach.

While mutual funds offer key benefits such as diversification and professional fund management, it is important to keep a close eye on the cost of investing. This is because, effectively, it weighs down on your returns.

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You see, fund houses when they manage a respective scheme, besides the fund management fees, incur a variety of expenses such as legal and audit fees, custodian charges, brokerage, research-related, on advertising and marketing, and administration, among others.

All these costs are encapsulated in one and charged to you, the investor, in the form of an expense ratio.

The Total Expense Ratio (TER) is calculated as the total expenses of a scheme divided by the total AUM (Assets Under Management).

Therefore, it is expressed as a percentage of the fund's daily net assets. The TER has a direct bearing on the scheme's Net Asset Value (NAV). Hence it is one of the important parameters to select a mutual fund scheme.

The capital market regulator, SEBI, has regulated how expense ratio open-ended, close-ended, and passively managed schemes can charge.

Table 1 A: Maximum TER on equity funds and debt funds

Assets Under Management (AUM)	Max. TER that equity funds can charge	Max TER that debt funds can charge
On the first Rs 500 crore	2.25%	2.00%
On the next Rs 250 crore	2.00%	1.75%
On the next Rs 1,250 crore	1.75%	1.50%
On the next Rs 3,000 crore	1.60%	1.35%
On the next Rs 5,000 crore	1.50%	1.25%
On the next Rs 40,000 crore	Total expense ratio reduction of 0.05% for every increase of Rs 5,000 crore of daily net assets or part thereof.
Above Rs 50,000 crore	1.05%	0.80%

Source: SEBI

Table 1 B: TER Limit for close-ended funds and passive funds

Type of scheme	Maximum TER (in %)
Equity-oriented close-ended or interval schemes	1.25%
Non-equity-oriented close-ended or interval schemes	1%
Index Funds/Exchange Traded Funds (ETFs)	1%
Fund of Funds investing in actively managed equity-oriented schemes	2.25%
Fund of Funds investing in actively managed non-equity-oriented schemes	2%
Fund of Funds investing in liquid, index, and ETFs	1%

Source: SEBI

Over and above this, mutual funds can charge 30 basis points (bps) more if they manage to tap higher of (a) 30% of gross fresh inflows of the scheme or (b) 15% of the average AUM (year to date) of the scheme from B30 cities (beyond top 30 cities).

It means that schemes with large AUMs are likely to have lower expense ratios but those collecting more AUM from the tier-2 and tier-3 cities can charge higher expense ratios. This is essentially done to encourage fund houses to make efforts to get inflows from these cities.

Moreover, between the Regular Plan and the Direct Plan, the latter has a lower expense ratio as compared to regular plans. This is for the obvious reason that with direct investing, much of the costs towards commissions paid by fund houses to the distributors and the marketing cost is reduced.

PersonalFN analysed 972 schemes across scheme categories to understand the trends in the expense ratios.

The newer fund houses incur higher costs on the distribution, as explained by the difference between the expense ratios of their Regular plan and Direct Plan.

For instance, the difference in the Direct and Regular Plans of mutual fund schemes such as ITI Mid Cap Fund, Navi Large Cap Equity Fund, Quant Value Fund, and Shriram Balanced Advantage Fund is 200 bps or more - the highest across categories.

In the absence of any track record, their schemes need to be hard-pushed. Do you remember any instance wherein your bank relationship manager or a mutual fund distributor hard-sold any scheme from the stable of a newer fund house?

Table 2: Investing in schemes offered by newer fund houses costs you more

Scheme Name	Category	Expense Ratio
		Direct Plan	Regular Plan
ITI Mid Cap Fund	Mid Cap Fund	0.32	2.62
ITI Small Cap Fund	Small cap Fund	0.32	2.62
ITI Value Fund	Value Fund	0.32	2.62
ITI Large Cap Fund	Large Cap Fund	0.32	2.57
ITI Long Term Equity Fund	Equity Linked Savings Scheme	0.38	2.58
Navi Large Cap Equity Fund	Large Cap Fund	0.31	2.51
Navi Large & Midcap Fund	Large & Mid Cap	0.35	2.51
Quant Focused Fund	Focused Fund	0.57	2.62
Quant Value Fund	Value Fund	0.57	2.62
Shriram Balanced Advantage Fund	Dynamic Asset Allocation	0.6	2.6

Expense Ratio data as of 30 April 2022
(Source: ACE MF, PersonalFN Research)

In the case of newer fund houses, you need to be ultra-careful.

As they incur higher distribution expenses, you must ensure they aren't compromising on other critical expenses such as fund managers' compensation, research-related expenses, and legal, among others, and are following the stipulated TER norms prescribed by the SEBI.

Keep in mind, Global Funds, Fund of Funds (FoFs), New Fund Offers (NFOs), and sector and thematic funds typically have a higher expense ratio.

Factors such as high churning, low AUM, and frontloading of expenses adversely affect the expense ratios of the sector and thematic funds. On the other hand, FoFs have some overlapping costs which are already charged by the underlying funds.

Table 3: Another reason to keep away from the sector and thematic funds besides high risk...

Scheme Name	Category	Expense Ratio
		Direct Plan	Regular Plan
ITI Banking & Financial Services Fund	Banks & Financial Services	0.32	2.62
Nippon India Japan Equity Fund	Global	0.09	2.28
Navi 3 in 1 Fund	Multi Asset Allocation	0.34	2.4
Quant ESG Equity Fund	Thematic Fund	0.64	2.69
Invesco India ESG Equity Fund	Thematic Fund	0.25	2.27
Baroda BNP Paribas Business Cycle Fund	Thematic Fund	0.28	2.11
Invesco India Infrastructure Fund	Infrastructure	0.82	2.64
Aditya Birla SL ESG Fund	Thematic Fund	0.49	2.26
Kotak Manufacture in India Fund	Thematic Fund	0.67	2.42
Quant Infrastructure Fund	Infrastructure	0.64	2.39

Expense Ratio data as of 30 April 2022
(Source: ACE MF, PersonalFN Research)

The average difference between the expense ratios of Direct Plans and Regular Plans is 0.8% which, according to PersonalFN, is quite a lot. Now you must be wondering how much difference this can make to your overall return.

An investment of Rs 10,000 per month through a Systematic Investment Plan (SIP) would fetch you Rs 12.5 lakh less in a Regular Plan after 10 years as compared to a Direct Plan.

In 15 years, this difference would swell to Rs 19.1 lakh and Rs 26 lakh over 20 years. Over and above that, if your mutual fund scheme underperforms by another 0.8%, your notional losses could widen.

Hence, is important to make your investment decision not just looking at the expense ratio but a host of quantitative and qualitative parameters such as the following:

• Returns over various time frames - 3-month, 6-month, 1-year, 2-year, 3-year, 5-year, 10-year, and since inception.
• Performance across market phases (i.e., bull and bear phases) in the case of equity-oriented schemes.
• Performance across interest rate cycles (upward and downward) in the case of debt-oriented schemes.
• Risk ratios (Standard Deviation, Sharpe, Sortino, etc.)
• The AUM and expense ratio of the scheme.
• Portfolio characteristics. In the case of equity funds, the top-10 holdings, top-5 sector exposure, how concentrated/diversified is the portfolio, the market capitalisation bias, the style of investing - value, growth, or blend - and the portfolio turnover. In the case of debt funds, the average maturity, modified duration, and the quality of debt papers.
• The quality of the fund management team (experience of the fund manager, the number of schemes he/she manages, the track record of these schemes, the experience of the research team.
• And the overall efficiency of the mutual fund house in managing the investors' hard-earned money, i.e. the proportion of AUM actually performing.

Also, pay attention to the investment processes and systems at the respective fund house.

If you find two or more funds with a similar performance track record and quality of fund management (after shortlisting schemes based on the aforesaid parameters), you may consider selecting a fund with a lower expense ratio.

However, bear in mind that expense ratios are not static and may rise in the future.

It is important to invest in scheme/s that have a dependable track record.

And when you have zeroed in on the best funds (from the respective category and sub-category) in congruence with your risk profile, broader investment objective, and the time horizon, invest in the Direct Plan whereby the cost of investing is lower, and you potentially clock efficient risk-adjusted returns.

Happy Investing!

Disclaimer: This article has been authored by PersonalFN exclusively for Equitymaster.com. PersonalFN is a Mumbai-based Financial Planning and Mutual Fund research firm known for offering unbiased and honest opinions on investing.