Now you know what CAGR and XIRR is. Followed by very diligent research, you have shortlisted top 5 mutual funds you plan to invest in. Of course, you have an eye for the detail. No way you skipped the cute little text that says ‘expense ratio‘. But since, there was ‘at most’ a difference of just a teeny tiny 1%, you chose to skip that. Who cares? Right? Well you should. Let’s unfold what is expense ratio in mutual funds and how does it impact your returns.
What is Expense Ratio?
So, first things first. Why am I being charged for investing in a mutual fund? Aren’t returns going to take care of the salaries of all those fund managers? Well yes. But here’s the catch. You pick a mutual fund for investing. That mutual fund is associated with an AMC (Asset Management Company) to manage all it’s assets. AMC has a lot of costs involved like auditing expenses, advertising, commissions etc. These AMCs very conveniently pass on these costs to the mutual fund companies which in turn, charge you for these expenses.
How do I Pay Expenses?
There is no need of paying these expenses separately. Mutual fund companies adjust this amount in your NAV and hence it has a direct impact on your returns.
Let’s Talk Numbers:
So we’ve established that what is this expense ratio and it does impact my returns. But how much? So let us compare fund A and fund B. Fund A doesn’t charge you anything whereas fund B charges you 1% expense ratio. You decide to invest Rs. 2,00,000 in both these funds for a period of 20 years. Both these mutual funds give you a CAGR of 10%.
Fund A Returns:
Applying the formula of compound interest,
Final Amount= p(1+r)n
Where ‘p’ is your principal, ‘r’ is rate of interest and ‘n’ is Number of years.
= the amount inclusive of returns fetched by Fund A are Rs. 13,45,499.
Fund B Returns:
Applying the similar formula,
=2,00,000(1+(0.1-0.01))20 (Deducting the expense ratio of 1% from the rate)
= the amount inclusive of returns fetched by Fund B are Rs. 11,20,882.
So, just a seemingly small expense ratio of 1% downgrades your returns by a massive 2.24L. Obviously, higher the amount, period or rate, higher is the impact.
You need not worry about calculating this difference manually each time. There are multiple calculators online that will help you do it. (Example)
I hope that next time onwards, you will NOT ignore this percentage no matter how small it is. After all, this one odd percent has the potential of making a difference equivalent to a couple months EMI of your home loan. Or may be a diamond necklace your spouse wants for her birthday. Or may be, top variant and base variant of your dream car. You get the point.
Until Next Time. . .