Expense ratios: a quite wealth killer which eats up your mutual fund gains

Business Standard

17 hours ago

Imagine two friends, Ramesh and Neha, who each invested Rs 10,00,000 in mutual funds 20 years ago. Ramesh chose a fund with a 2 per cent expense ratio, while Neha opted for one with a 0.5 per cent ratio. Both funds delivered the same gross return of 10 per cent annually. Today, Neha's portfolio is worth around ~62,00,000, about ~15,00,000 more than Ramesh's. A huge difference, right. Actually, expense ratio fees nibbled into Ramesh's wealth over the course of 20 years.
This quiet wealth killer is the expense ratio, the annual fee charged by mutual funds.
For most mutual fund investors, expense ratios are an often-overlooked detail. But experts warn that these fees can have a significant impact on long-term returns, especially when compounded over decades.
Why do expense ratios matter?
'Expense ratios are the annual fees that mutual funds charge for managing your money. These may range from 0.2 per cent to around 2 per cent,' says Arjun Guha Thakurta, executive director at Anand Rathi Wealth.
While passively managed index funds tend to have lower expense ratios (0.2 per cent-0.7 per cent), actively managed funds can go as high as 2 per cent.
'Over the long term, even a 1 per cent difference in costs can erode wealth substantially. If a fund consistently delivers returns above its benchmark, a higher expense ratio may be justified. Otherwise, that extra 1 per cent is simply a drag on your wealth,' Thakurta explains.
Navy Vijay Ramavat, managing director at Indira Group, agrees.
'Expense ratios are deducted daily from fund assets, reducing NAV and lowering returns. For example, a fund generating 10 per cent returns before expenses with a 2 per cent expense ratio delivers only 8 per cent net returns. Over 20 years, that small difference could result in ~267000 less wealth per ~1000000 invested, a 43.6 per cent difference in final accumulation,' he notes.
Active vs passive: What's worth paying for?
Should investors prioritise low-cost index funds to minimise expenses? Not always, Thakurta says.
'In a developing market like India, small and midcap companies offer significant growth potential. Here, active funds, despite higher costs, may justify their fees if they generate consistent alpha.'
Ramavat suggests a balanced approach.
'For core portfolio allocations, low-cost index funds can provide broad market exposure at minimal cost. Active funds can be used selectively in niche segments where managers have a proven ability to outperform.'
What's considered high or low?
As a rule of thumb, expense ratios below 1 per cent for equity funds and 0.5 per cent for debt funds are considered low in India. Ratios above 1.5 per cent for equity and hybrid funds or 0.75 per cent for debt funds are on the higher side, says Thakurta.
Sebi also prescribes upper limits based on fund type and size, providing a regulatory framework to assess reasonableness.
Reducing the drag without sacrificing returns
'Switching from regular to direct plans can shave off 0.3 per cent to 0.7 per cent annually, adding up to meaningful savings over time,' Ramavat points out.
He also recommends using a core-satellite portfolio, combining low-cost index funds for the bulk of investments with carefully chosen active funds in specialised areas.
'Regular monitoring is critical. If a fund's expense ratio increases without an improvement in performance, consider switching,' Ramavat adds. However, he cautions against hasty exits.
'For existing holdings, weigh tax implications before making a move.'
The bottom line
Expense ratios may look like a small percentage, but their impact on compounding is huge. By making informed choices and ensuring that every rupee paid in fees delivers value, investors can significantly boost long-term wealth creation.