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Just because a fund is cheap, should you invest in it?

Does expense ratio really matter for your mutual fund investments?

Expense ratios are frequently getting revised these days. Do you need to act upon it? Does expense ratio really matter for your mutual fund investments? 

Let's understand first the term ‘expense ratio’.

It includes all expenses incurred in fund operations including fund management fees, registrar and transfer agent fees, sales commission and other related costs. A fund’s NAV is declared after accounting for such expenses on a daily basis. Annual expense ratio of one percent signifies that every year about one percent of your portfolio go towards paying these expenses.

Cheap and best

Expense ratio of a fund affects portfolio returns. For instance, an investment of Rs 1 lakh into a fund with one percent expense ratio appreciates to Rs 1.69 lakh over a five-year period (at 12 percent per annum). It will be yield Rs 7,455 more than a fund having an expense ratio of two percent. 

Regulatory miss


Since April of this year, Sebi, the mutual fund regulator, reduced the upper limit for expenses. Expense ratio of open-ended equity (oriented) funds has been capped at 2.25 percent, while it is 2 percent for the rest. Moreover, it is subject to asset size; more the asset size, lesser the fund could charge. 

However, many funds continue to have higher expense ratios than prescribed by Sebi and some are even revising it upwards. 
Investors need to adopt a diverse strategy based on the category of the fund.

1. Large cap equity funds
Currently, large cap funds charge anywhere from 1.69 to 2.67 percent. Some are charging off-limits. However, all large cap funds with asset size about Rs 10,000 crore are currently charging lower than 2 percent.  If you want to invest in large cap fund, choose a good performer with a large asset under management. This will automatically bring down its expenses. And with ample liquidity in the large cap space, its size will not come in the way of performance. 

2. Index funds
Equity index fund passively mimics the portfolio of the index under consideration. This is one category, where expense ratio acts as a key differentiator. Index funds and exchange-traded funds can’t charge more than 1 percent annually, as per current regulations. 

Exchange-trade-funds or ETF (below 0.2%) have been found to be much cheaper than a traditional index fund.  Choose an index fund which is cheap and has the least tracking error.

3. Midcap and small cap
No other fund category has so much divergent performance as a midcap or a small cap. If you had invested in a small cap fund last year, your returns could have been anywhere from -19% to a positive 22%. 

For these categories of funds, outperformance matters more than the expenses. Invest in funds with superior performance, rather than just in those with lower expense ratios. 

4. Debt funds
In case of debt funds, where the absolute gains are relatively smaller, expense ratios are usually lower. As against the regulatory cap of 1 percent, liquid funds are, on an average, charging only about 0.29 percent. 

Go beyond just returns, and look at portfolio construction, while investing in short-end debt funds. Often, funds with higher expense ratio take higher portfolio risk in order to cover up expenses. Compare apples and apples and scout for large-sized assets which in turn will bring down expenses.

Takeaway
Expense ratio matters – be it for debt or equity funds. Choosing a fund with large size can bring down expense ratios. But such strategies can backfire in case of small cap or midcap funds. In short, look for value and not just a cheap fund.

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