Expense ratio: When less spells more

Seemingly small things can sometimes make a big difference. This truism becomes more visible when it relates to your investments. The best example of this is the expense ratio, which can make a big difference to your returns when you invest in mutual funds. Before exploring how expenses impact your mutual fund returns, let’s understand the exact meaning of the expense ratio and what costs it includes.

Expense ratio is the total annual cost charged by the mutual fund to manage the investors’ money. It is the total annual expenses incurred by the fund in relation to its average annual assets. This includes the management fees as well as operating expenses like registrar and transfer agent fees, audit fees, custodian fees, advertising expenses and distribution fees. These expenses are taken out of the fund’s assets before calculating the final value of the assets under management (AUM), which in turn, is used to arrive at the net asset value. Therefore, in simple words, the expense ratio is the per-unit cost incurred to manage the funds.

As per the Securities and Exchange Board of India (SEBI) regulations, a mutual fund can charge a maximum of 2.5 per cent in expenses for equity funds, 2.25 per cent for debt funds, 1.5 per cent for index funds and 0.75 per cent for funds of funds. However, here we have considered only equity funds (including sector funds) to know how the expense ratio impacts the returns of mutual fund schemes.

Although these expenses do not look very significant in the short term, the compounding effect over the longer term results in these seemingly small expenses impacting your portfolio returns heavily. To understand this, let’s work out the difference in a scenario wherein you have invested Rs 1 lakh in a mutual fund scheme that generates an average return of 15 per cent and has expense ratio of 0.25 per cent in one case and 2.5 per cent in another case. After 10 years, the total corpus will be around Rs 395000 in case of the scheme with 0.25 per cent expense ratio. Keeping all other factors constant, if the expense ratio is 2.5 per cent, the corpus at the end of 10 years will be Rs 325000. The Rs 70000 (almost 18 per cent) difference in the two schemes is an astounding 70 per cent of your initial investment. Even if we consider a five-year investment horizon, the difference in returns is still around 10 per cent (see graph to learn more). Hence, the expense ratio cannot be ignored while making your investment decisions, as a higher expense ratio can hurt your investment performance.

Now consider this. There are more than 400 equity funds with an average expense ratio of 2.03 per cent. What this means is that currently around Rs 5200 crore is expensed for managing funds of around Rs 2.16 lakh crore. One may argue that funds with higher expense ratios could be generating higher returns to compensate for the expense ratio. To test this, we tried to find out the correlation between the last three years’ annualised returns provided by funds and their expense ratios, and found that there is hardly any relation between these two factors. Even after regressing the data, we do not find that the expense ratio impacts returns in any way. What makes the situation even worse is that in tough years like 2011, in which equity funds have yielded negative returns on an average, the expense ratio further depresses the returns.

Hence, it makes sense to invest in funds that have a lower expense ratio, keeping other things constant, like the risk taken. On the other hand, there is a negative correlation between funds with lower AUM and the expense ratio. What this means is that funds with lower AUM have higher expense ratios. For example, most of the funds having AUM of less than Rs 50 crore have their expense ratio as more than two per cent. This is barring ETFs and funds of funds that are passively managed, and thus, have a lower expense ratio.

Another significant cost that drags down the returns is the turnover ratio. This cost is also deducted from the asset value before arriving at the NAV. The turnover ratio measures the changes in a mutual fund’s assets and how frequently the fund manager churns its portfolio during the given period. It is calculated by dividing the lower of total sales or total purchases by its average monthly assets during a given year. A higher ratio means that churning happens frequently. Therefore, a turnover ratio of 100 per cent means that the fund manager has replaced the entire portfolio during the period.

A high turnover ratio hits your returns in two ways. First, the more a fund trades in securities, the higher are the trading costs such as brokerage and other taxes. Secondly, the fund has to pay capital gains tax for any trade that is profitable. What this means is that if a fund has a turnover ratio of more than 100, it has to pay more short term capital gains tax, which always works out more than long term capital gains tax. Hence, it makes sense to have a higher turnover ratio only if the profit generated by such transactions overcomes the cost associated with it. For the 300 equity funds that we have analysed, we found a negative correlation between their turnover ratios, and the returns generated by these funds are also very feeble.

However, one should not directly filter out funds that have a high turnover ratio, especially when they are generating better returns than their peers. The problem arises when a fund is trading heavily but not generating proportionate returns. Moreover, a low turnover ratio could even imply that the fund manager is not reacting to changing market situations.

Although a high expense and turnover ratio will weaken a mutual fund's performance, a fund should not be automatically screened out ration this count. What should be important to you is the fund's return net of expenses, that is the returns computed from NAVs. A fund that can beat its peers on a risk-to-return basis after expenses is a clear winner, and one should go for it. However, if these expenses are significantly higher than those of the category average, you should be careful while committing your funds.

Series 1: High Expense Ratio (2.5%)

Series 2: Low Expense Ratio (0.25%)
 
Different Fund Categories And Their Turnover And Returns         

Category	Average Of Turnover (%)	Average Of Returns (3 year)	Number Of Funds
FMCG	34.5	37.62	2
Others	34.92	23.2	28
Technology	35.52	34.97	5
Pharma	39.92	38.44	3
International	46.57	19.92	13
Multi-Cap	55.06	27.58	36
Mid & Small-Cap	59.72	30.46	49
Infrastructure	62.32	19.09	16
Large & Mid-Cap	62.42	24.43	50
Tax Planning	62.43	25.47	32
Large-Cap	71.9	22.9	50
Banking	114.51	33.36	10

Different Fund Categories And Their Expense Ratio And Returns

Category	Average of 3-Year Returns	Average Of Expense Ratio	Number Of Funds
Banking	33.36	1.63	10
FMCG	37.62	2.48	2
Infrastructure	19.38	2.06	20
International	20.14	2.01	17
Large & Mid-Cap	24.6	2.1	57
Large-Cap	23.42	1.66	56
Mid & Small-Cap	30.53	2.24	53
Multi-Cap	27.46	2.18	37
Others	23.2	2.35	28
Pharma	38.44	2.4	3
Tax Planning	25.47	2.25	32
Technology	34.97	2.3	5