Significance of Expense Ratios
When we say that Fund X has returned 20% in a year—is that return based on the difference in NAV? If it is based on NAV, and since expense ratio is deducted on a daily basis from the net assets, is it right to say that the returns are exclusive of the expense ratio? So, if expense ratio is 2%, my return is still 20% and not 18%? In that case, if Fund A has post-expense return 20%, expense ratio 2% and Fund B has post-expense return 20%, expense ratio 4%, can an investor choose either fund and get the same return?
MLF’s Reply: Mutual fund returns are calculated based on their NAVs which are post-expenses. Therefore, it is right to say that the returns are after factoring in expenses.
If 20% is your return calculated on the basis of the percentage difference in NAV, this is your actual return. Please note, an exit-load may be charged as per the terms for your scheme.
Please note also that expense ratio does affect returns. In the hypothetical scenario taken, schemes with different expense ratios were delivering the same returns. However, the actual return (pre-expense) of Fund A is 22% and for Fund B is 24%.
The fund manager of Fund B would have picked better stocks; hence, better returns even after the high expense ratio.
Will the fund manager of Fund B always perform? This is cannot be predicted. If, over the next one year, both the fund managers deliver a pre-expense ratio return of 18%, the returns of Fund A after the expense ratio would be 16% and that of Fund B would be 14%. In this scenario, Fund A outperforms.
Therefore, expense ratios need to be considered, among other factors, such as consistency in performance, portfolio composition and benchmark related performance, etc.
It may not always be true that the fund manager of a scheme with a higher expense ratio will be able to significantly outperform a scheme with a low expense ratio.
When I invest through a financial advisor, how much commission does the advisor get at the first investment and thereafter regularly. For example, on dividend payouts or at any other time?
MLF’s Reply: Distributors of mutual fund products are paid two types of commissions: upfront commissions and trail commissions. Some fund houses pay only upfront or only trail or a mix of upfront and trail commissions. Systematic investment plans have a different commission structure.
Upfront commissions are paid on fresh investments that come into a scheme. Therefore, if the distributor brings in an investment of Rs1 lakh and the fund house pays an upfront commission of 2%, the distributor will earn Rs2,000.
Trail commission is an annual commission which is paid on the value of existing investments that the distributor has brought into a scheme. Trail commissions are calculated on a daily basis as a percentage of the assets under management of the distributor and payable monthly. Therefore, the total value investments in the scheme is around Rs1 lakh and fund pays a trail commission of 0.25% per annum, the distributor will earn Rs250.
The commissions are not fixed. The exact commissions paid may vary, depending on what is negotiated between the distributor and the asset management company.
However, you need not worry about the commissions earned by your distributor. The fund house charges you a fixed annual fee or expense ratio which has a limit as per SEBI (Securities and Exchange Board of India) regulations. Whatever the distributor gets is included in this ratio. You would need to check on the website of the fund house for the exact expense ratio charged. It is important to look for a lower expense ratio along with other selection parameters.
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