Last Updated on September 5, 2022 at 4:53 pm
A reader asks, “I have a query regarding mutual fund expense ratios. Let’s say, we have Fund A with 5-year returns of 15% and expenses of 0.5%. Fund B, with returns of 18% with an expense ratio of 1.2%”.
“I consider Fund B as a better fund as it has a better return even after a high expense ratio, with an assumption that all other factors are the same. I have seen multiple articles suggesting funds with a lower expense ratio are better. Could you please provide your valuable inputs/suggestions?”
There are two issues here. The first is the assumption of ceteris paribus, which is Latin for “all other factors are the same”. This is never the case! Comparing two mutual funds is tricky, and abundant caution is necessary.
Take the simplest case. Let fund A and B both Sensex index funds (direct plan, growth option). A has a TER (total expense ratio) of 1%, and B has a TER of 0.5%. Can I automatically assume that fund B is the better choice?
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! 🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
There is a good chance that it is, but those other things are never the same. The tracking ability of two fund managers is never the same. Even if we assume this is not a significant factor, the open-endedness of the mutual funds can cause plenty of problems.
The AUMs of both funds can be quite different. One fund A can be aggressively recommended by an investment portal, and the other relatively unknown. Regular plans are important even in the case of index funds. The two AMCs can “incentivise” their sales force differently (particularly during the NFO period), affecting the AUM. We recently reported that about 31% of the total index fund AUM is in regular plans! See: Which direct plan equity mutual funds do investors prefer?
All these factors would mean the returns of funds A and B are not dependent on their TERs alone. It is quite possible for a fund with 1% TER to outperform a fund with 0.5% TER. Investors often make this mistake while comparing index funds with ETFs, which are less expensive. Unfortunately can be quite expensive since retail investors will have to buy and sell units from other investors in the pool. See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!
So while comparing index funds, the tracking error in terms of actual return differences matter more than expense ratios. Interested readers can consult our monthly index fund tracking error screener for this data. In the case of ETFs, one should calculate tracking error or return differences with the ETF price and not NAV. This is, unfortunately, a bit tough to accomplish for now.
Now let us look at the example provided by the reader: Fund A with 5-year returns of 15% and expenses of 0.5%. Fund B returns 18% with an expense ratio of 1.2%. If these were actively managed funds, only the performance matters since the NAV is post expenses.
However, this brings us to the second issue: hindsight. When we start investing, we have no idea what the return after a year will be, while every day, the TER is deducted from our investments and represents a real return for AMC and their sales guys.
So we can only say in hindsight which fund was better, the less expensive one or, the more expensive one! What is the way out, then?
In the case of active funds, comparing two funds can be a frustrating experience for investors, and we recommend against it regardless of TER. For index funds, a reasonably low TER and reasonably large AUM is all that is required. Low AUM can result in bizarre outcomes. See: Six Index Funds “outperform” their benchmarks! Beyond this, we urge investors not to fret about expense ratios. They are subject to change anyway.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)