In our view, it’s high time investors put the expenses they are incurring on their investments, in the right perspective. In mutual funds, this is represented by the expense ratio.

Put simply, the expense ratio denotes that percentage of the mutual fund’s total net assets/corpus that goes towards meeting its expenses. These expenses are recurring in nature and must be differentiated from one-time expenses like loads (on entry and exit). The fund’s recurring expenses that are broadly covered by the expense ratio are fund management fees, the marketing and selling expenses and registrar fees, among other charges.

All these expenses are borne by the mutual fund. In other words, all these expenses are deducted from the net assets/corpus of the fund. Since the NAV (net asset value) per unit is based on the net assets, higher net assets for a given number of units will result in a higher NAV. Conversely, lower net assets for a given number of units will result in a lower NAV. Since expenses erode the net assets, one way for a mutual fund to improve its returns is by keeping expenses on the lower side.

• Mutual Funds: Cost to investor

However, investors would do well to understand that this doesn’t mean that funds with lower expense ratios are necessarily better than the funds with higher expense ratios. Investors should appreciate that the expense ratio is just one parameter amongst many others, which is used to judge a fund’s attractiveness. What a lower expense ratio effectively does is that it provides investors with a better chance to rake higher returns.

Let’s take an example to understand the effect of expenses on a fund’s performance. Consider two similar funds, A and B. The expense ratio of Fund A is 2.25% and that of Fund B is 1.75%. Suppose an investor invests Rs 200,000 in both the funds, and both funds charge 2.25% as entry load. Assume that the funds clock a growth of 15% per annum and that the investor stays invested for a tenure of 10 years.

The Rs 200,000 investment in Fund A (which has a relatively higher expense ratio), will appreciate to Rs 629,931 at the end of 10 years. Conversely, the same amount invested in Fund B (with a lower expense ratio), will grow to Rs 662,904. Effectively, the lower expenses charged by Fund B fetch investors an additional sum of Rs 32,973 over the 10-Yr period.

Now, assume that the same investments are made over even longer time frames, say 25 years. In that case, the disparity in returns from both the funds widens to approximately Rs 495,665.

A few assumptions have been made in the above calculations.

1. Expense ratios of both the funds have been assumed to be constant throughout the investment tenure. Under normal circumstances, expense ratios could vary over a period of time, especially with a growth in the fund’s assets under management.

2. Also the rate of return has been assumed to stay constant throughout the investment tenure. In reality, the returns may vary across time horizons depending on factors like the market conditions, among others.

It is evident that as the investment tenure grows, the benefits on account of “conservative” expenses grow exponentially. Investors, who add mutual funds to their investment portfolios as a part of a financial planning exercise, typically tend to have longer investment horizons. Funds charging lower expenses can play a significant role in aiding such investors achieve their investment objectives.

• Use our Expense Ratio Calculator to find out how expenses impact returns

While comparing the expense ratios of two or more funds, investors must make sure that comparison is done between comparable funds i.e. a diversified equity fund must only be compared with a diversified equity fund. Comparing different types of funds would fail to show the true picture. Hence, index funds, which traditionally tend to have lower expense ratios, should not be compared with diversified equity funds.

Finally, as mentioned earlier, the expense ratio is one amongst various factors, which needs to be considered while evaluating a mutual fund scheme. However, it shouldn’t be considered in isolation. Investors would do well to give this factor its due weightage in the evaluation process.