Should You Focus Much on the Expense Ratio When Investing in Mutual Funds

February 17, 2024 Mutual Fund

Recently, the most searched term on Google was ‘What is Expense Ratio in Mutual Funds’.

It seems that mutual fund investors are laying much emphasis on the Expense Ratio, along with past historical performance and mutual fund star ratings.

Speaking of the Expense Ratio, it is nothing but the costs that are levied on the mutual fund scheme (by the fund house) as a percentage of its daily net assets. The costs incurred by the fund house on their schemes are investment management fees, brokerage on buying and selling securities, registrar & transfer fees, custodian fees, legal fees, audit fees, sales & marketing/advertising expenses, administrative expenses, and so on. These costs are levied on the mutual fund scheme as a percentage of its daily net assets and are referred to as the Total Expense Ratio (TER).

The TER is charged to the NAV of the mutual fund scheme. The daily NAV of a mutual fund scheme is disclosed after deducting its expenses.

At present, in India, the Expense Ratio is fungible. Meaning, there is no limit on any particular type of allowed expense as long as the total expense ratio is within the prescribed limit. The limits as prescribed by the capital market regulator, SEBI, currently are as under:

Table 1: TER limits for actively managed equity and debt schemes

(Source: www.sebi.gov.in) 

Table 2: TER limit for passive mutual fund schemes

(Source: www.sebi.gov.in) 

Last year, in March 2023, SEBI stopped the additional TER of up to 30 basis points for ‘Below-30 cities’ (B-30), i.e. in the case of small cities, citing misuse and lack of uniformity in its applicability.

Later, in May 2023, working in the interest of investors, SEBI released a Consultation Paper on Expense Ratio, proposing to overhaul the Expense Ratio structure of mutual funds.

Among the many proposals, the regulator recommended that the Total Expense Ratio (TER) be charged at the fund house or AMC level and not at the scheme level.

Moreover, the TER must be inclusive of all costs and expenses, including GST on management fees, brokerage and transaction costs, B-30 incentives, etc.

The regulator also proposed separate new TER slabs for equity-oriented mutual funds and non-equity-oriented ones. For Hybrid mutual fund schemes, it cited that their TER shall be the weighted average of TER of equity & equity-related instruments and TER of other than equity & equity-related instruments.

[Read: How SEBI is Planning to Overhaul the Expense Ratio for Mutual Fund Investments]

Besides, the regulator put across the idea of a performance-linked expense ratio taking cognisance of the underperformance of many actively managed mutual funds, particularly under the Regular Plan rather than the Direct Plan, given that it’s not in the interest of investors.

[Read: SEBI Proposes Two Approaches to Performance-linked Expense Ratio for Mutual Funds]

While many of the proposals of SEBI’s consultation paper are under review, they are intended to bring in transparency and accountability, ensure a level playing field in the Indian mutual fund industry as a whole (whereby the small fund houses are not disadvantaged), and encourage funds to perform better by aligning the interest of fund managers with that of investors.

[Read: SEBI Proposes Sweeping Reforms for Expense Ratio of Mutual Fund Investments]

That being said, I believe investors should not give too much focus or emphasis only on the Expense Ratio charged by a mutual fund scheme.

The Expense Ratio is just one of the various quantitative parameters that go into selecting the best mutual fund schemes.

Keep in mind that while a high Expense Ratio may weigh down on the mutual fund scheme’s performance, it is also not necessary that a mutual fund scheme with a low expense ratio is always better. So, only to an extent the Expense Ratio is important if the scheme is not justifying its performance.

If the mutual fund scheme is compensating well, i.e. generating respectable returns against the risk exposure (by holding a robust portfolio by following sound investment processes and systems), then the Expense Ratio is well justified.

Do note that if you give much attention to only the Expense Ratio, past returns, and/or star ratings (which are not foolproof), you may be missing the other vital aspects of picking the best mutual fund schemes.

You see, to choose among the best mutual funds across categories and sub-categories, as an investor, you need to prudently evaluate a host of quantitative and qualitative parameters of the scheme, such as…

• Returns over various time frames (6-months, 1-year, 2-year, 3-year, 5-year, 10-year, since inception)
• Performance across market phases (i.e. bull and bear phases)
• Performance across interest rate cycle (in the case of debt mutual funds)
• The current interest rate cycle (in the case of debt mutual funds)
• Risk ratios (Standard Deviation, Sharpe, Sortino, etc.)
• Portfolio characteristics (the top-10 holdings, top-5 sector exposure, how concentrated/diversified the portfolio is, the market capitalisation bias, the style of investing followed – value, growth, or blend, the portfolio turnover, and in the case of debt mutual funds the quality of debt papers held, the average maturity, and modified duration)
• The overall efficiency of the mutual fund house in managing investors’ hard-earned money (i.e. the proportion of AUM actually performing. This shall reveal whether the fund house is an asset gatherer or a prudent asset manager.)
• The quality of the fund management team (the experience of the fund manager, the number of schemes he/she manages, the track record of the mutual fund schemes under his/her watch, and the experience of the research team)

In addition, understanding the investment ideologies, plus the processes and systems followed at the fund house, could prove useful. Watch this video:

This deep evaluation helps in gauging the risk-return potential of a fund, i.e. how it would perform in the future and helps in choosing among the best and consistent performers.

To keep your cost of investing low, consider Direct Plans offered by fund houses. The Expense Ratio of the Direct Plan is lower than that of the Regular Plan (since mutual fund houses do not have to pay commissions to distributors). Even a small difference in the Expense Ratio between these two plans could make a huge difference to your investments.

[Read: Even 1% Difference Can Make a Huge Difference to Your Investments]

Furthermore, when you invest in mutual funds, for it to be a thoughtful choice, consider your age, risk profile, broader investment objective, financial goal/s, and the time in hand to accomplish the envisioned goals. Doing so shall enable you to hold mutual funds schemes that are not only among the best but even suitable ones that align with your needs.

As regards whether to invest a lump sum or choose SIP (Systematic Investment Plan), shall depend on the market condition, investible surplus, and liquidity needs. But usually, at the market high or when there is high volatility — which is the case at present — and you are planning for long-term financial goals, it is sensible to take the SIP route. The inherent rupee-cost average feature of SIP would help mitigate the risk involved while you endeavour to compound your hard-earned money. SIPs are a useful medium for financial goal planning.

[Read: How to Invest in Mutual Funds]

As good things take time, when you invest in mutual funds, ensure you give enough time to your portfolio to perform and avoid making any decisions based on short-term returns.

Be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here