Must Read: Impact of Expense Ratio on investment returns: Should you worry!

What is Expense Ratio?

Simply put, Expense Ratio is the amount an investment company charges as a fee for managing your fund. This could be for a Mutual Fund, your NPS account, a ULIP you own or your overall investment portfolio if you plan to offload it to a fund manager. And this ratio generally varies from 0.1% to 2.5% based on the instrument of choice. Some Index Mutual Funds charge around 0.1%-0.2%, regular equity mutual funds charge around 1.2-1.5%, whereas for ULIPs this can go up to 2.5%. 

Isn’t this just a negligible difference? Should I break my head over it?

In hindsight, this might look like a small difference of 1-2%, and not something you should be worried about. The key thing to note here is that this expense is charged on a yearly basis on the total investment you own, whether you make a profit or loss. So, the longer you invest your money in a fund with a higher expense ratio, the more you lose as an expense for managing the fund.

We understand that this could confuse you a lot and might already make you wonder if you should continue reading this article. To keep things simple, we used some illustrations to explain this difference in detail. We did this covering both the best and worst-case investment return scenarios considering the fluctuations in market cycles. Let’s assume a best-case scenario where you earn an average return of 12% a year in a bull market and a worst-case scenario where you earn an average return of 6% a year in a bear market.

Illustration 1: Assuming an investment of Rs 1,00,000 for a period of 5 years invested in a regular mutual fund charging an Expense Ratio of 1.5%

Best Case Scenario: 12% return with an Expense Ratio of 1.5%

InvestmentRs. 1,00,000
Time Period5 years
Average Return12% p.a.
Expense Ratio1.50%
YearStart of the YearReturn %Return AmountExpensesEnd of the Year
11,00,00012%120001,5001,10,500
21,10,50012%132601,6581,22,103
31,22,10312%146521,8321,34,923
41,34,92312%161912,0241,49,090
51,49,09012%178912,2361,64,745
  • Expense for 5 years = Rs 9,249
  • Return Before Tax = Rs 64,744
  • After-tax Return (30% slab) = Rs 45,321
  • Expense Amount as a percentage of after-tax return = 20%

As you can see, you end up paying Rs 9,249 as an expense for an after-tax return of Rs. 45,321, which is close to 20% of your final return. 


Now, let’s look at the worst-case scenario.

Worst Case Scenario: 6% return with an Expense Ratio of 1.5%

InvestmentRs 1,00,000
Time Period 5 years
Return (CAGR) 6% p.a.
Expense Ratio1.50%
YearStart of the YearReturn %Return AmountExpensesEnd of the Year
11,00,0006%6,0001,5001,04,500
21,04,5006%6,2701,5681,09,203
31,09,2036%6,5521,6381,14,117
41,14,1176%6,8471,7121,19,252
51,19,2526%7,1551,7891,24,618
  • Expense for 5 years = Rs 8,206
  • Return Before Tax = Rs 24,618
  • After-tax Return (30% slab) = Rs 17,232
  • Expense Amount as a percentage of after-tax return = 48% (~50%)

In the worst-case scenario, you end up paying Rs 8,206 as an expense for an after-tax return of Rs 17,232, which is close to 50% of your final return. The funny thing to notice here is that your profit has more than halved from Rs 45,321 to Rs 17,232, while your expense has just reduced by approximately 1,000. 

House Always Wins
The House Always Wins!

Illustration 2: Assuming an investment of Rs 1,00,000 for a period of 5 years invested in a direct mutual fund charging an Expense Ratio of 0.5%

Best Case Scenario: 12% return with an Expense Ratio of 0.5%  

InvestmentRs. 1,00,000
Time Period5 years
Average Return12% p.a.
Expense Ratio0.50%
YearStart of the YearReturn %Return AmountExpensesEnd for Next Year
11,00,00012%12,0005001,11,500
21,11,50012%13,3805581,24,323
31,24,32312%14,9196221,38,620
41,38,62012%16,6346931,54,561
51,54,56112%18,5477731,72,335
  • Expense for 5 years = Rs 3,145
  • Return Before Tax = Rs 72,335
  • After-tax Return (30% slab) = Rs 50,634
  • Expense Amount as a percentage of after-tax return = 6%

Some interesting facts here too. Now you pay only 6% of what you earn as a return and your after-tax return has increased by approximately 5,000 (Rs 50,634 – Rs 45,321). This difference turns out to be huge when the time period of investment increases further. You could see this towards the end in Illustration IV.


Now, let’s look at the worst-case scenario.

Worst Case Scenario: 6% return with an Expense Ratio of 0.5%   

InvestmentRs 1,00,000
Time Period 5 years
Average Return 6% p.a
Expense Ratio0.50%
YearStart of the YearReturn %Return AmountExpensesEnd of the Year
11,00,0006%6,0005001,05,500
21,05,5006%6,3305281,11,303
31,11,3036%6,6785571,17,424
41,17,4246%7,0455871,23,882
51,23,8826%7,4336191,30,696
  • Expense for 5 years = Rs 2,790
  • Return Before Tax = Rs 30,696
  • After-tax Return (30% slab) = Rs 21,487
  • Expense Amount as a percentage of after-tax return = 13%

You can see here that with a low expense ratio, even in a worst-case situation where the market returns are not investor friendly you still pay only 13% as the investment manager’s commission unlike 50% when the expense ratio was 1.5%.

Now witness the Magic of Compounding

Let’s look at these scenarios when you invest for a slightly longer time period, say 10 years

Illustration III:  Assuming an investment of Rs 1,00,000 for a period of 10 years with expense ratios varying from 0.2% to 2.5% and an average return of 10%

We have done a similar analysis like what we did above and found some interesting results, here too

Expense Ratio2.5%1.5%0.5%0.2%
Expenses for 10 years35,36822,2537,7803,157
Return Before Tax 1,06,103 1,26,0981,47,8231,54,697
Return After Tax (30% slab) 74,272 88,269 1,03,4761,08,288

The difference in return before tax for expense ratios of 0.2% and 2.5% (Rs 1,54,000 – Rs 1,06,103) is approximately Rs 50,000. There is a pre-tax difference of almost 50% of the total amount invested (Rs 1,00,000) when your time period changes to 10 years. 

Let’s compare ULIP and Index Mutual Fund

We increased the amount to Rs 5,00,000 to better compare with ULIPs

Illustration IV:  Assuming an investment of Rs 5,00,000 for a period of 10 years with expense ratios varying from 0.2% to 2.5% and an average return of 10%.

Generally, ULIPs would be for an investment of 5 lacs, spread across 5 years (1 lac each year). For simplicity, we are assuming a lump sum amount of 5 lacs deposited at the beginning of year 1 and withdrawn after 10 years. We found some interesting results here too.

Expense Ratio2.5%1.5%0.5%0.2%
Expenses for 10 years1,76,8391,11,26338,90115,785
Return Before Tax 5,30,5166,30,4927,39,1147,73,484
Return After Tax (30% slab) 3,71,3614,41,3445,17,3805,41,439

Interestingly, you can see here that the return with an expense ratio of 0.2% is close to double the return with an expense ratio of 2.5%. You might be wondering that ULIP is tax-free, but even after excluding the tax component, the after-tax return of an index mutual fund (Rs 5,41,439) with an expense ratio of 0.2% is higher than the tax-free return (Rs 5,30,516) from ULIP that charges an expense ratio of 2.5

Note: We are not against ULIPs, many ULIP plans charge an expense ratio lower than 2.5% (close to 2%), and ULIP also offers insurance apart from just investment returns. This article is intended for those people who are evaluating them purely from an investment point of view. We would like to shed some light on how they should evaluate the underlying expense ratios while comparing various investment options to choose the right one for them. 

Conclusion

Expense Ratio plays a vital role in the choice of your investment vehicle and should be researched thoroughly to ensure you do not end up just paying commission at the cost of your compounded returns.

Our Recommendation

To understand this better and to gain more perspective on the beauty of index funds and the magic of compounding we recommend you The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John C. Bogle, founder of Vanguard group that pioneered Low-Cost Index Mutual Funds. It’s definitely worth the read!

Disclaimer: We are not recommending a specific class of instrument here, our endeavour here is to educate the retail investor on how a meagre difference in expense ratio could have a large impact on the overall returns over a period of time.

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