When you invest in a mutual fund a percentage of what you earn as returns is subtracted to pay for the fund manager, fund distributor, advertising and other expenses. This is referred to as expense ratio.
For example if you invest Rs. 1 lakh in a fund and if the fund returns 10% in a year the amount will grow to Rs. 1,10,000. If a mutual fund quotes an expense ratio of 1%, then 1% of 1,10,000, that is 1,100, will be deducted and the value shown in the statement will be 1,08,900. This represents a return of 8.9% (not 10% – 1% as you might think!). For an expense ratio of 2% the value will be 1,07,800 or a net return of 7.8%. A difference of only 1,100 one might think. For just a few years this does not matter much. Unfortunatelythe decrease in value due to the difference in expense ratios compounds if you stay invested for a long period of time. For example over a 15 year period the difference is 50,749 for 10% yearly returns. For 15% returns the difference is 98857.
Now consider a SIP investment of 5000 each month the MF with 1% expense ratio grows to 295463 and the MF with 2% expense ratio grows to 2667413 a difference of 10% or 2.91 lakhs!
So expense ratio is an important factor in selecting a mutual fund but not the only factor. Let us list the factors:
1 long term consistent performance over all market trends
2. good risk-return parameters: high alpha, low beta, low standard deviation and high Sharpe ratio
Download the step-by-step guide to selecting a mutual fund to find out what these ratios are.
3. Once you have short-listed funds on the basis of 1 and 2 you could choose the one with the lowest expense ratio.
Use this calculator to understand how expense ratios can impact returns over a long period.