Your fund's annual cost

What is expense ratio • Asset managment companies charge investors an annual fee for managing their money • This charge varies from 0.2% to 2.5%, which is the maximum that Sebi rules allow in a year • The money is used for meeting various expenses • These include cost of mailing statements and cheques, advertising, trustee fees and custodian charges • Also includes fund management charge, with a 1.25% ceiling

What is the most important yardstick for choosing a mutual fund? Returns? Indeed, how much the investment will earn should logically be the key factor guiding your decision. But there is no way anyone can predict how a mutual fund will perform in future. The past performance of a fund is like a rear view mirror in a car—it gives you an idea of the broad direction but can’t tell you exactly where you are headed.

While an investor cannot predict how much a fund will earn, he can certainly know how much he is paying the fund house, in fees and other charges. Besides the entry and exit loads levied at the time of buying and selling, fund houses also charge investors an annual fee for managing their money. Also known as the expense ratio, this annual charge varies from fund to fund. A diversified equity fund may have an expense ratio of 2.5% a year while a passively managed index fund from the same fund house may be content with just 1%. An exchange-traded fund may charge just 0.5% a year.

The money is used for meeting the various expenses of the fund, including cost of mailing account statements, dividend and redemption cheques, advertising expenses, trustee fees, custodian charges and fund management charges.

Fund houses do not have a free hand in charging the expense ratio. Sebi guidelines allow funds to charge 2.5% for average daily net assets of up to Rs 100 crore, 2.25% for the next Rs 300 crore and 2% for the next Rs 300 crore. If the AUM is bigger, the maximum charge on the balance is 1.75%.

A 2.5% annual charge may seem insignificant in the short term, but if you are a long-term investor, it can make a big difference to your overall return (see table). If you invested Rs 50,000 in fund B that charged 0.75% and your friend invested in fund C which charged 2.25%, at the end of 15 years, you would have about Rs 35,000 more than him simply because your fund’s annual fees was lower. Of course, this calculation assumes that both funds earned the same nominal return.

During a bullish phase of the stock markets, it is easy to overlook the expense ratio. Who cares for a 2.5% charge when the fund is earning 30-35% a year? But as the past three months have demonstrated, bull runs don’t last forever. In bearish times, a percentage point saved is a percentage point earned.

How it is charged The expense ratio is expressed as an annual charge, but is deducted on a daily basis from the NAV.The NAV is declared after deducting expenses. This amortises the cost over the year and ensures all investors (short-, medium- and long-term) pay it.
How it impacts your returns
	Fund A	Fund A	Fund A
Expense ratio	0%	0.75%	2.25%
Investment (Rs)	50,000	50,000	50,000
Nominal returns*	10%	10%	10%
Value after 5 years (Rs)	80,525	77,817 Loss: 3.4%	72,620 Loss: 9.8%
Value after 10 years (Rs)	1,29,687	1,21,111 Loss: 6.6%	1,05,473 Loss: 18.7%
Value after 15 years (Rs)	2,08,862	1,88,492 Loss: 9.75%	1,53,189 Loss: 26.7%
The loss implies the percentage by which the value of the investment is lower because of the expense ratio *Actual returns earned by fund without adjustment of inflation and expenses

The expense ratio is particularly critical in case of debt funds. That’s because these funds in any way give low returns of 8-10%. If a debt fund earns a nominal return of 10%, then a 2% expense ratio can shave off a fifth of its returns. If you factor in the 10% tax on the longterm capital gains from debt funds and 5% inflation, you are left with barely 2.5% real returns.

This, however, does not mean that investors should focus only on expense ratio when selecting a fund. Weigh the savings on expenses against the performance of a fund. Use expense ratio as a differentiator only when you have to choose between two similar funds.

The expense ratio is mentioned in the offer documents and fact sheets. Generally, the bigger the fund corpus, the lower the recurring charge because the expenses are amortised over a larger AUM. But the unwieldy size of large funds can also pose a problem. Smaller funds tend to be more nimble and generate higher returns than large funds.

For instance, the best performing equity fund in the past one year is the Standard Chartered Premier Equity Fund. Its corpus of Rs 582 crore is one-tenth the size of ICICI Prudential Infrastructure Fund, the largest equity diversified fund. So, if a fund charges a high expense ratio but gives superior returns, it may not be so bad after all.

While evaluating a fund for investment, the trend in expense ratio over the years is more important than just the figure for a particular year. For instance, in the past three years, Reliance Vision’s expense ratio has declined from 2.23% to 1.84% while JM Basic Fund’s expense ratio rose from 1.66% to 2.3%. A declining expense ratio shows that its growing AUM is helping moderate its costs or that the fund is cutting costs. It also gives the investor an idea of how much his investment is likely to be impacted by the expense ratio.