For most investors, the only parameter on which their mutual fund investments are evaluated is 'returns.' In fact, investors are so pre-occupied with tracking returns that they are treated as the investment's 'be all and end all.'
While the importance of returns cannot be denied; there are other vital areas like the fund's expenses and loads that go virtually unnoticed. Expense ratios and entry/exit loads generally find a mention in offer documents and fact sheets; and here's the clincher -- they have a significant bearing on the fund's performance!
In this article, we study what these parameters mean and how they impact the fund's performance. The 'expense ratio' refers to recurring expenses incurred by the fund on areas like investment management and advisory fees, marketing and selling expenses amongst others.
The limits for these expenses are prescribed by the Securities and Exchange Board of India and have been expressed as percentage of the fund's corpus size.
The fund's net asset value (NAV) is computed after factoring in the abovementioned expenses, hence higher the expenses charged by fund, lower are the returns received by investors.
Typically expense ratios for a diversified equity fund could range anywhere from 1.5 per cent to 2.5 per cent. However these seemingly tiny numbers have a more important significant impact than most investors can possibly fathom.
An example should help us help us better understand the same. Let us compare two diversified equity funds, Fund A and Fund B. Both the funds deliver the same performance, i.e. a consistent 15 per cent growth rate every year. However, the differentiating factor is the expense ratio. While Fund A consistently maintains an expense ratio of 1.5 pre cent, it stands at 2.0 per cent for Fund B.
Lower expenses = Higher returns!
| Fund A | Fund B | |
| Exp ratio:1.5% | Exp ratio:2.0% | |
| Year end | 50,000 | 50,000 |
| 1 | 56,638 | 56,350 |
| 2 | 64,156 | 63,506 |
| 3 | 72,673 | 71,572 |
| 4 | 82,320 | 80,661 |
| 5 | 93,248 | 90,905 |
| 6 | 105,627 | 102,450 |
| 7 | 119,649 | 115,462 |
| 8 | 135,532 | 130,125 |
| 9 | 153,524 | 146,651 |
| 10 | 173,904 | 165,276 |
Ten years hence, an initial amount of Rs 50,000 amounts to Rs 173,904 in the case of Fund A, while it would be Rs 165,276 for Fund B. This disparity will only get further magnified over a longer period.
If your investment objective is to build a corpus for retirement or buying a house property, you are likely to stay invested over a much longer period, say around 20 years.
In such a scenario, while the investment in Fund A would be Rs 604,855, the one in Fund B would add-up to just Rs 546,322; a difference of more than Rs 50,000, i.e. the initial investment amount.
This should convince skeptics of the importance of even 50 basis (0.50%) points in the expense ratio.
Rank top performing diversified equity funds
Now for loads. Simply put, loads represent a price paid by investors for participating in the scheme. While an entry load is charged at the time of making an investment, an exit or 'back-end' load is charged at the time of redemption.
Loads, like the fund's expenses have a direct influence on the investor's returns. For example if a fund charges an entry load of 2 per cent on an investment of Rs 10,000, it will amount to an investment of only Rs 9,800 (Rs 200 is deducted as the load) from the investor's perspective.
Hence as an investor you have a lower investment amount working for you, which also has an impact on the returns clocked. Only big-ticket investments (and investments made using the systematic investment plan route) enjoy a waiver in the entry load; for a retail investor, the entry load is a recurring expense to be borne with each investment made.
Investors would do well to scrutnise how their funds 'perform' on the expenses and loads parameters vis-à-vis their peers before making any investment decision. However care must be taken to ensure that the comparison is a fair one.
If you are contemplating getting invested in a diversified equity fund, compare its expense ratio with that of another fund from the same segment. Comparing an equity fund with a debt fund or a monthly income plan will amount comparing apples with oranges; and would produce lop-sided results.
Having stated the importance of expenses and loads, investors must realise that they are one among a host of factors that must be taken into consideration before an investment decision is made.
The fund's investment objective, the investor's risk appetite and investment tenure, the fund manager and his management style are some of the other factors that have to be considered while making a mutual fund investment.
Lower expense ratios and loads cannot guarantee that the fund will deliver a superior performance. However your chances of landing up with a better performing fund will grow significantly if you are invested in a fund that keeps its expenses down.
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