Why Best Expense Ratio Matters When Investing in Mutual Funds

In turbulent market conditions, even a small difference in costs can lead to significant variations in long-term returns. Investors need to carefully evaluate not just the returns offered by mutual funds but also the associated costs that directly affect net earnings. The expense ratio, often overlooked by novice investors, plays a pivotal role in determining the actual profitability of a fund.

This article explains what is expense ratio, how it is calculated, and why it is crucial for mutual fund investors.

What Is Expense Ratio?

The Expense Ratio is essentially the annual fee charged by a mutual fund house to manage your investments. It represents the operational cost of running the fund and is expressed as a percentage of the average assets under management (AUM).

For example:

• If a mutual fund has an expense ratio of 1.5%, this means the fund charges Rs 1.50 for every Rs 100 invested annually.

Components of Expense Ratio

The expense ratio includes:

1. Fund Management Fees: The fees paid to fund managers for managing the portfolio.

2. Administrative Costs: Expenses for record-keeping, compliance, and maintaining operations.

3. Marketing and Distribution Costs: Costs incurred to promote and distribute the mutual fund.

Types of Expense Ratios

• Direct Plan: These plans exclude distribution costs, making the expense ratio cheaper.

• Regular Plan: These plans include commissions for distributors and are higher in cost with a high expense ratio.

How Is Expense Ratio Calculated?

The formula for calculating the expense ratio is:

Expense Ratio (%) = (Total Operating Expenses / Average AUM) × 100

Where:

• Total Operating Expenses include management fees, legal fees, audit fees, and other costs incurred to run the fund.

• Average AUM is the average of the fund's total assets over a specific period.

Example Calculation:

Let's say a mutual fund has:

• Total Operating Expenses: Rs 50 crore

• Average AUM: Rs 10,000 crore

Then, the Expense Ratio = (50 / 10,000) × 100 = 0.50%.

Why Does Expense Ratio Matter?

1. Direct Impact on Returns

The Expense Ratio is deducted from the fund's gross returns, thereby reducing your net returns. For instance:

If a mutual fund earns 10% in a year and its expense ratio is 2%, your net return will be only 8%.This makes expense ratios especially crucial during volatile markets where every basis point matters.

2. Compounding Effect Over the Long Term

In long-term investments like Systematic Investment Plans (SIPs), even small differences in expense ratios can lead to significant differences in the final corpus due to the compounding effect.

[Read: SEBI to Tighten Disclosures on Expenses, Expense Ratio, Returns, Yields and Risk-o-Meter for Mutual Funds]

3. Passive Funds and Expense Ratio

In index funds and ETFs, which track a benchmark index, the expense ratio becomes even more critical. Lower costs ensure returns are closer to the index, as these funds do not aim to outperform the benchmark.

4. Suitability for Large Investments

For high-net-worth individuals (HNIs) and institutional investors, even a slight reduction in the expense ratio can lead to substantial savings in costs, enhancing overall returns.

5. Transparent Cost Structure

Funds with lower expense ratios often signal efficient management practices. Investors can rest assured that their money is being utilised efficiently rather than being eroded by high costs.

Expense Ratio Trends in 2025

In 2025, mutual fund houses are under pressure to keep expense ratios competitive as investor awareness grows and SEBI regulations tighten. Direct plans have gained traction as they offer significantly lower costs compared to regular plans.

Additionally, actively managed funds are facing scrutiny to justify their higher expense ratios by delivering superior returns in the face of market uncertainties.

Categories of Mutual Funds and Expense Ratios

To make well-informed investment decisions, it is crucial to compare funds within their respective categories. Below is a curated list of mutual funds featuring competitive expense ratios across equity, hybrid, and debt categories.

1. Equity Mutual Funds (Growth-Oriented)

Equity funds typically have higher expense ratios due to active management, but the following funds balance performance with costs:

2. Hybrid Mutual Funds

Hybrid funds combine equity and debt for moderate risk and returns. Here are some with reasonable expense ratios:

3. Debt Mutual Funds

Debt funds generally have lower expense ratios, ensuring higher net returns for conservative investors:

One of the most notable distinctions between Direct and Regular plans in mutual funds lies in their expense ratios. Direct plans inherently have a lower expense ratio compared to regular plans, as they bypass the need for intermediary commissions paid to distributors or advisors.

[Read: Should You Focus Much on the Expense Ratio When Investing in Mutual Funds]

While the difference in expense ratios may appear minimal at first glance, its impact becomes profound over the long term, thanks to the power of compounding. This cost efficiency in direct plans allows a larger portion of your investment to grow uninterrupted, ultimately resulting in a significantly higher corpus over time.

Calculation is based on the compound interest formula: A=P×1+rn

Difference: Rs 60,12,000 - Rs 53,49,000 = Rs 6,63,000/-

The difference in expense ratio, even as small as 0.5%, results in a wealth gap of Rs 6.63 lakhs after 20 years. This highlights how reducing costs by opting for direct plans can significantly boost your long-term returns.

Why Are Expense Ratios Lower in Direct Plans?

In regular plans, fund houses pay commissions or fees to intermediaries, such as distributors or financial advisors, who facilitate the sale of mutual funds. These fees are built into the expense ratio of the fund. Direct plans, on the other hand, are purchased directly from the fund house, eliminating the need for intermediaries and their associated costs. This results in a lower expense ratio for direct plans.

For example, if the Expense Ratio of a Regular Plan is 1.5%, the Direct Plan of the same fund might have an expense ratio of 1.0% or even lower. Over time, this small difference compounds, making direct plans a more cost-efficient option for investors.

Benefits of Choosing Direct Plans

• Higher Returns: Lower expense ratios directly increase the returns generated by the mutual fund, as more of the returns are reinvested rather than deducted as costs.

• Transparency: By eliminating intermediaries, investors have greater control and visibility over their investments.

• Ideal for DIY Investors: Direct plans are suitable for investors who prefer to research and manage their own portfolios without the need for regular advice.

Expense Ratio: One Parameter Among Many

While the expense ratio is an important consideration when selecting a mutual fund, it is not the only factor. Investors must also evaluate:

- Fund Performance: Historical returns, risk-adjusted performance, and consistency

- Investment Goals: Suitability of the fund based on financial objectives and risk tolerance

- Fund Manager Expertise: The track record of the fund manager and their ability to navigate market conditions

- Fund Category: The type of fund (equity, debt, hybrid, etc.) based on your investment horizon and risk profile

By considering these factors holistically, investors can make better-informed decisions and build a portfolio that aligns with their financial goals. Hence, even though the direct plans offer cost benefits, their suitability depends on the investor's ability to manage their investments independently.

To summarise...

While the Expense Ratio plays a crucial role in the long-term growth of your mutual fund investments, it is important to remember that it is just one piece of the puzzle.

Ultimately, the key is to strike a balance between cost-efficiency and the level of support you require in managing your investments. By carefully evaluating all the relevant parameters, investors can make well-informed decisions that align with their financial objectives and enhance their wealth-building journey.

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MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.
She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.
 

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.