Does the Expense Ratio in Mutual Funds Really Matter? Here's the Truth

When you invest in a mutual fund, you're likely focused on one thing: returns. However, behind the performance numbers is a small yet powerful cost known as the Total Expense Ratio, or TER. It’s a cost that can quietly eat into your profits over time.

But if a fund is delivering significant returns after all its costs, should you even care about the expense ratio? The answer isn't a simple yes or no. Let's break it down.

What Exactly is the Total Expense Ratio (TER)?

Think of the TER as an annual management fee you pay to the mutual fund company (Asset Management Company or AMC) to handle your money. This fee is deducted from the fund's assets and is reflected in its Net Asset Value (NAV). You don't pay it directly from your bank account, but it reduces your overall returns.

What does the TER include?

• Fund Management Fees: Salaries for the fund managers and their research team.
• Administrative Costs: Expenses incurred for managing the fund, including record-keeping, customer service, and legal fees.
• Marketing & Distribution Costs: Advertising expenses and commissions paid to distributors (in the case of Regular Plans).
• Goods and Services Tax (GST): This tax is applied to the fund management fee.

The "Total" in TER Can Be Misleading

Here’s a crucial point: the "Total" Expense Ratio doesn't actually cover all the costs associated with running a fund. Several other charges are not included in the TER, which can further impact your returns:

• Brokerage and Transaction Costs: Charges incurred when the fund manager buys or sells stocks.
• Securities Transaction Tax (STT): A tax levied on the value of securities transacted through a stock exchange.
• Exit Loads: A fee charged if you sell your fund units before a specified period. This money, however, is reinvested in the fund, benefiting the remaining investors.

For example, a fund that frequently buys and sells stocks (has a high turnover) will incur higher transaction costs, a detail not captured in the TER.

SEBI's Framework on TER 

The Securities and Exchange Board of India (SEBI) has set limits on how much a fund can charge as TER. The fee is not a flat rate; it's based on a tiered system that depends on the fund's size or Assets Under Management (AUM). As a fund grows larger, the percentage it can charge as TER decreases.

Here are the maximum TER limits set by SEBI, effective from April 1, 2020:

So, Does the Expense Ratio Really Matter?

Surprisingly, the immediate answer is no if your fund is beating benchmark returns or meeting your expectations. The returns and NAV you see are always calculated after the TER has been deducted. So, if your fund is beating its benchmark or meeting your expectations, the cost is already factored in. Because the performance mutual funds display is after the expense ratio, so what you see is what you get. However, this is only half the story. The expense ratio becomes critically essential in several situations.

1. Direct Plans vs. Regular Plans

When you invest, you have two choices:

• Direct Plan: You invest directly with the AMC. There are no middlemen, so the costs are lower.
• Regular Plan: You invest through an intermediary, such as a bank, distributor, or financial advisor, who earns a commission.

This commission is built into the TER of a Regular Plan, making it more expensive.
Regular Plan TER = Direct Plan TER + Distributor Commission

This seemingly small difference in cost has a huge impact on performance over time. Data from a SEBI consultation paper shows a stark contrast:

• Underperformance: A massive 40.30% of Regular plans underperformed their benchmark by more than 1.25%. In contrast, only 26.22% of Direct plans did so.
• Outperformance: Only 26.67% of Regular plans managed to meet or beat their benchmark. Direct plans fared much better, with 44.77% meeting or outperforming the benchmark.

The conclusion is clear: the higher costs embedded in Regular plans lead to significantly worse performance over the long term.

2. The AUM Effect: Bigger Funds, Smaller Gaps

The gap between Direct and Regular plan TERs is often wider in smaller funds (e.g., those with less than ₹5,000 crore in AUM). These funds may offer higher commissions to distributors to attract more investors, which inflates the cost for investors in Regular plans.

Larger funds, on the other hand, tend to have a smaller difference between their Direct and Regular plan expense ratios. However, if you are investing in a smaller fund, choosing the Direct plan becomes even more crucial to avoid these higher commission costs.

3. Passive & Liquid Funds: Where TER is King

In specific fund categories, the expense ratio is the most critical factor to consider.

• Passive Funds (Index Funds & ETFs): These funds don't attempt to outperform the market; instead, they aim to replicate a market index, such as the Nifty 50. Since there is no active fund management strategy in place, there is no reason to pay a high fee. When comparing two index funds that track the same index, the one with the lower TER will almost always give you a better return.

For instance, two Nifty 50 index funds, one charging 0.10% and another 0.80%, can have significantly different long-term returns despite tracking the same index.

• Liquid Funds: These funds invest in short-term debt and are designed for safety and modest returns. Because the returns are already low, even a small difference in the expense ratio can significantly impact your take-home earnings. Some liquid ETFs charge as much as 0.69%, which is a substantial cost for a low-return product.

Expense Ratios Can Vary

Unlike a fixed fee, a mutual fund's TER can be changed by the AMC at any time. While SEBI mandates that fund houses must inform investors of any changes, a sudden hike can negatively affect your future returns. This makes it essential to keep an eye on the expense ratio of your chosen funds periodically.

Final Thoughts

While a fund's post-TER return is what ultimately lands in your pocket, the expense ratio is a critical detail you can't afford to ignore.

It is the primary reason for the performance gap between Direct and Regular plans and the most important factor when choosing passive or liquid funds. By opting for low-cost Direct plans, you ensure that a larger portion of your investment returns stays with you, compounding over time to build significant wealth.

Disclaimer: The content is meant for education and general information purposes only.  Past performance is not indicative of future returns. This in no way is to be construed as financial advice or a recommendation to invest in any specific stock or financial instrument. The Company strongly encourages its users/viewers to conduct their own research, and consult with a registered financial advisor before making any investment decisions.  Mutual Funds are non-exchange traded products, and INDstocks is merely acting as a mutual fund distributor. All disputes with respect to distribution activity, would not have access to the exchange investor redressal forum or arbitration mechanism. Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing. INDstocks Private Limited (formerly known as INDmoney Private Limited) 616, Level 6, Suncity Success Tower, Sector 65, Gurugram, 122005, SEBI Stock Broking Registration No: INZ000305337, Trading and Clearing Member of NSE (90267, M70042) and BSE, BSE StarMF (6779), AMFI Registration No: ARN-254564, SEBI Depository Participant Reg. No. IN-DP-690-2022, Depository Participant ID: CDSL 12095500, Research Analyst Registration No. INH000018948 BSE RA Enlistment No. 6428.