TLDR - What is expense ratio, what are its components, how does it impact you and distinction between active and passive funds

The typical mutual fund investor does not worry about expense ratios. Sad, but true as per the data from AMFI. They would look at the star rating of a fund based on morningstar or valueresearchonline or their banking platform and invest in the funds. Most likely invest in regular plans instead of direct plans and pay a good 0.25% to 1.0% in yearly expenses to the distributors.

But since you are here and you want to learn more, let us break this down.

TER = total fund costs / total fund assets

Simple enough. But what constitutes the fund expenses

1. Operating costs

   • Fund manager pay, research and analysis, booking keeping, marketing expenses, support costs etc.

2. Trading costs

   • For an Index fund, this cost is typically small, given that the you purchase the index and are not actively trading. For actively traded funds with a larger turnover the costs will be higher

3. Distributor commission (in case of regular funds)

   • Direct funds do not need to pay any distributor commissions, but regular plans that you purchase through a bank or other distributor carries an additional cost anywhere between 0.25% to 1.0% depending on the fund.

4. Legal fees

   • Legal costs involved with fund operations

5. Auditing costs

   • Internal and external audits of the financials of the fund

6. Documentation and communication costs

7. Taxes

   • Any relevant taxes on top of trading costs that needed to be borne by the AMC.

For an actively managed mutual fund regular plan, you are hit in two places mostly

• Distributor commissions

• Trading costs

all other being equal.

So what can you do to choose a good fund on top of fundamentals

1. Direct plan - Fund distributor is adding no value except for selling you the fund, why pay them 0.25% to 1% in perpetuity until you hold the fund, switch a direct plan

2. Fund size - larger the fund size, (typically but not always) the smaller the expense ratio - 1% of 1000 Cr AUM is much smaller compared to 0.5% of 20,000 Cr AUM. Larger funds are able to shave expense ratios charged because of their size.

3. Focused funds - generally have lower turn over which brings down trading costs

4. Index funds - tend to cheaper because of even lower trading costs than active funds

We have already established that index funds are better option than large cap funds here and here.

You might as well optimise even further on the expenses to achieve the best possible results on our hard earned money.

Conclusion

I am in the process of moving more and more of my portfolio into index funds, which we had more options beyond NIFTY and NIFTY JR funds to get us there. Vanguard is killing it with expense ratios of 0.04% in some of its most popular funds.

We still languish at an average TER across funds of

1.83% for regular equity funds

1.14% of direct equity funds.

0.27% for direct index funds

Based on average of all equity funds data from valueresearchonline.

More than expense ratios, we need more index funds which represent a wider spectrum of the market. One can always dream, can’t we?

Happy Investing.