Similarly, when you invest in a mutual fund scheme, you ought to pay a fee to the professionals managing your fund. After all, why would someone make an effort for managing your money for ‘free’?
The fee you ought to pay the mutual fund company is the ‘expense ratio’
In simple terms, the expense ratio measures how much of a fund’s assets are used for administrative and other operating expenses. It is calculated by dividing a fund’s operating expenses by the average dollar value of its Assets under Management (AUM).
ER= Total Fund Costs/Total Fund Assets
And mind you, this is a critical aspect of investing! Although the expense ratio of a mutual fund scheme may be insignificant in the short term, it can significantly eat into your returns in the long term.
For instance, if you invest Rs 10,000 initially for a 20-year time frame and the fund generates 10% annual returns, here is a scenario analysis showing expense ratios and their effect on returns:
As can be seen in the table, expense ratios can eat up to 30% of your returns in the long run. So for a corpus of Rs 10 crores, you have lost Rs 3 crores just by paying fees.
The Bottom Line
Higher expense ratios eat into nominal returns for investors. And active funds carry higher expense ratios than passive funds.
Although expense ratios have been trending lower for years, they can’t be ignored while investing. But at the same time, it should be analysed in sync with other metrics such as the expected returns and the risks involved.
There has to be a tradeoff between the risk-return and expenses part. For one dominating the other can derail your investing journey!
