Most investors, seasoned or otherwise, dedicate a significant space in their portfolio to mutual funds. As mutual funds are managed by professionals and are considered relatively safe, they offer peace of mind and lucrative opportunities for portfolio diversification. However, one must not forget about the costs associated with managing and monitoring the fund. The cost of managing a fund and ensuring it operates per the defined investment goals is computed and charged to investors in the form of the Expense Ratio. It is a vital number investors must pay attention to while making mutual fund investment decisions.
This article throws light on the expense ratio and its effects on an investor’s potential earnings and financial planning considerations.
What Does Expense Ratio Mean?
The expense ratio refers to the expenses an investor bears when they invest in mutual funds. This is the fee investors must pay fund management companies that operate, manage, and maintain the fund on behalf of all the investors partaking in the given mutual fund. This fee covers the costs incurred by fund managers for various crucial tasks, such as meeting statutory compliance requirements, maintaining records, fulfilling the relevant legal requirements, and coordinating audits, among other things. Also, costs connected with promoting a mutual fund are transferred to investors, including marketing and advertising expenses.
Apart from these important matters, the fund management company or fund manager also oversees daily operations, including the buying and selling of assets. Another noteworthy task is market research, which helps fund managers select the right stocks to invest in. Further, fund management involves custodial services, since these comprise some of the toughest activities to manage. Custodial services safeguard financial assets, facilitate settlements, and enable dividend or interest processing (receipts and disbursements), to name a few functions covered under these services.
Fund management companies steer investor communications, keeping investors and other stakeholders updated about the happenings or decisions pertaining to the fund in question. Unless this function is handled well, investors will likely not be confident about how and where their money is being used and whether it is earning them the promised returns. Remember all those emails detailing a fund’s performance? They come with various financial reports attached—those are nothing but a form of investor communication. Other types include press releases, regulatory disclosures, open letters to investors, etc.
All the expenses listed above contribute to the expense ratio. In the next section, we will discuss how these expenses are accounted for in the final computation to arrive at the expense ratio of a fund.
How Is Expense Ratio Computed?
The expense ratio considers every expenditure related to managing and maintaining the fund. It is a portion, or percentage (to be more accurate), of the average quantum or volume of the Assets Under Management (AUM) of a given fund.
Expense Ratio = Total expenses related to a fund / Total assets in the fund
A recent report about Nippon India Mutual Fund talks about how the expense ratio affects an investor’s portfolio, particularly when it decreases. Given its importance, it is safe to say that the expense ratio is a major determinant that defines your returns. Naturally, it helps investors plan and rationalise their mutual fund investments.
How Does It Affect My Investments?
The amount attributable to the expense ratio is deducted from the returns before they are credited to an investor’s account. Hence, the expense ratio has a direct and significant impact on your earnings from an investment. Simply put, the higher the expense ratio, the lower the overall returns across the life of a mutual fund. For instance, if your returns are 5% and the fund’s expense ratio is 0.5%, you effectively receive only 4.5%.
But what happens when you hold your investment for longer periods? When you hold your investment for a significant long period, the effects of compounding begin. However, compounding is more effective when the base amount that is compounded is high. With a high expense ratio, the base amount (of returns) diminishes, making compounding less effective or useful.
Do you know the expense ratio affects the Net Asset Value (NAV) of a fund, too? The NAV is derived when you divide ‘the total assets’ by ‘the total shares’. When expenses are deducted from the asset value, the NAV goes down. Hence, it is advisable to look for funds with a low expense ratio.
When you think about investing in a particular fund, you must be mindful of the fact that other charges, fees, and taxes might be applicable in addition to the expense ratio. For instance, entry loads and exit loads lower your returns. Also, all applicable taxes will be deducted or payable later upon redemption. When you consider these potential additional costs, a low expense ratio becomes even more important.
Advantages of a Low Expense Ratio
When you weigh the benefits mutual funds offer, one goal that takes precedence is the return on investment. Fund selection, time of entry, and great performance record are carefully considered to earn a good sum. Since the expense ratio is expressed as a percentage, it may look negligible when you look at it in an offhand sort of way. But, to ensure you do not miss giving the expense ratio a serious thought, we have compiled the advantages of a low expense ratio.
- Good returns: A low expense ratio may give investors good returns. Compounding will have a considerable impact on year-on-year returns.
- High investment growth: As the fund amount is concentrated and focused efforts are initiated to ensure growth, the rate of growth is better with a low expense ratio. It means even when your portfolio expands and the fund balance increases, the expenses remain low or controlled, depending on the fund management strategies.
- High savings: Savings are comparatively higher with a low expense ratio than a high ratio. In simple words, you get more bang for your buck!
- Portfolio diversification: When investment-related costs are low, you can better enjoy the benefits of portfolio diversification since it facilitates investment in various asset classes.
We can, in no uncertain terms, conclude that a low expense ratio is beneficial. Trivialising or oversimplifying the expense ratio can be detrimental to your financial well-being in the long run. What experienced investors already know, new investors will learn as they continue to invest—a low expense ratio is a relief, given other costs and taxes one needs to bear during financial planning and, subsequently, while investing. Hence, as an investor, you must give the expense ratio adequate attention to ensure you make more money than you spend on making money.
If you are looking for investment advice and financial planning support, get in touch with our experts at Motilal Oswal.
Disclaimer: This blog has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The information/data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this blog are as on date. The blog does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.