Expense ratio – How to select mutual funds

The favourite question of most investors is “how to select mutual funds”. We inverted the question to “how NOT to select a mutual fund“.

In this post, we looked at factors like star ratings, past performance or brand names and the over importance they are given in fund selection. These factors, at best, can be used as a starting point in your mutual fund search.

Then we stepped further to look at the other oft searched query – top mutual funds to invest in. We made a list of the top 10 mutual funds by size and looked at various features of these schemes. It has been observed that investors don’t really pay attention to these factors. Instead they rely on just one factor – past performance.

In the fund selection exercise, there are factors, beyond performance of the fund, that need to be given due importance. These include:

• Investment Objective
• Investment Strategy
• Asset Allocation
• Expense Ratio (lower, the better)
• Turnover Ratio (how long does a stock/bond stay in the fund; lower, the better)
• Sharpe Ratio (how much additional risk has the fund generated for the risk taken; higher the better)

Let’s discuss one of these key factors – Expense Ratio.

Expense Ratio, really?

In 1966, the economist William Sharpe (who is credited with the creation of Sharpe Ratio) said, “all other things being equal, the smaller a fund’s expense ratio, the better results obtained by its stock holders.”

Running a mutual fund involves several expenses such as those for fund management (buying and selling of securities, research), registrar and custodian expenses, commissions paid to your distributor / broker, service tax on fund management, etc.

Who pays for these expenses? It is recovered from the money that you invest in the fund. When theses expenses are expressed as a % age of the fund value, it is called the Expense Ratio.

Now of course, funds need money to run those massive operations. But how much? While the regulator SEBI has capped the overall expenses that can be charged to various types of mutual funds, most of the funds operate on the higher side of this limit.

The expenses reduce the amount of money that would be available for investments and hence returns. Higher the expenses, lower the returns that your funds will deliver and vice versa.

Ideally, as the size of the fund goes up, not all expenses need to go up too. For example, the fixed expenses like salaries on the fund managers or the research team may not need to go up a lot. This should then bring down the expense ratio. As mentioned before, that’s not what is happening with most funds using the maximum limits.

The popular view

Unfortunately, expense ratio is the most neglected factor in fund selection. In fact, several investors justify a higher expense ratio by saying “as long as it generates superior returns, let them charge. How do I care?”

This attitude is more pronounced towards equity mutual funds as compared to debt or balanced funds. Equity funds have been able to generate double-digit returns for quite some time. The expenses appear too small in comparison to the high returns.

But that could be a mistake. Let’s look at the following table. 

It shows the value of an SIP of Rs. 10,000 every month growing at 12% and 12.75%. The numbers are for 3, 5, 10, 15 and 20 years.

The table above amply demonstrates how a 0.75% additional return per year (courtesy savings in expenses), over time results in about 44% extra total returns (as a percent age of your investments).

What do you have to say now?

Debt funds and expense ratio

Expense ratios are all the more relevant for debt funds. These funds invest in instruments such as corporate bonds, government securities, treasury bills, short term bonds in money market, etc.

In these debt funds, the returns are far subdued, compared to equity, and hence low costs is one of the most effective ways to deliver returns.

For example, an ultra short term debt fund would typically return about 8% a year. Can it afford to have expense ratios of 1% to 2% or more such as in equity mutual funds?

Everything else remaining the same, the expense ratio could be the difference between the winner and the loser.

Don’t take costs lightly.  Look carefully at the expense ratio figure of mutual funds that you are planning to invest in. A very high expense ratio should be considered as a warning sign.

Conclusion

You see, when it comes to investments, the only thing that YOU can definitely control is costs. You can choose low cost mutual funds. The determinant of that low cost is the expense ratio.

Direct Plans of mutual funds have emerged as an effective option to exercise this strategy. Direct plans do not pay out distributor commissions, at all.

Using direct plans, you, as an investor, can control as to how much do you want to pay for advice and how much for execution of your investment transactions.

What else can you control apart from costs? It is your behaviour.

Frequently buying and selling of funds, relying on short term tactics with no focus on long term goals, random transactions without awareness of what you are doing and why can lead to disastrous results. Keep a watch on your behaviour.

On that note, I wish you happy investing in mutual funds!

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