Does it make sense to choose mutual funds with the lowest expense ratio?

Published: January 7, 2022 at 7:00 am

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?

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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.

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