When we talk about investments in India, the conversation often revolves around returns – which fund performed best last quarter or which AMC (Asset Management Company) is currently topping the charts. However, in our pursuit of higher returns, we often overlook a critical factor that silently erodes our wealth over time – total expense ratio (TER). These seemingly small percentages can have a profound impact on your investment journey, especially when compounded over decades. Let’s explore exactly how much these fees matter using real numbers and practical examples relevant to Indian investors.

Understanding Expense Ratios: The Silent Wealth Eroder

Expense ratios represent the annual fee that mutual funds charge their shareholders. Expressed as a percentage of your investment, these fees cover fund management, administrative costs, marketing expenses (for regular plans), and distribution commissions. For example, an expense ratio of 1% means that for every ₹100 you have invested, you pay ₹1 annually in fees.

While this might seem negligible, these fees are deducted directly from your returns, not billed separately. This means they compound negatively over time, significantly impacting your wealth accumulation journey. In the Indian mutual fund landscape, we primarily have two types of plans:

• Direct Plans: Where investors purchase directly from the AMC without any intermediary, resulting in lower expense ratios
• Regular Plans: Where investors purchase through distributors (banks, brokers, or mutual fund distributors), who receive commissions, resulting in higher expense ratios

The difference between these expense ratios can vary significantly based on the fund type and category. For equity funds, this difference typically ranges between 0.5% to 1.5% – a gap that widens considerably over extended investment periods.

The Investment Comparison: Three Common Scenarios

To illustrate the impact of expense ratios, I’ve created a comparative model examining three common investment paths available to Indian investors:

1. Direct Index Fund with a 0.20% expense ratio
2. Direct Active Fund with a 0.63% expense ratio
3. Regular Active Fund (through a MFD bank) with 0.63% fund expense ratio plus 0.70% trailing fees, totaling 1.33%

For our case, let’s assume:

• Annual Investment: ₹10,000
• Investment Duration: 20 years
• Expected Return: 10% annually (before expenses)

These scenarios represent realistic options for most Indian investors. The first represents a low-cost index fund purchased directly from the AMC. The second represents an actively managed fund bought directly, while the third represents the same active fund purchased through a bank or distributor who charges additional trailing commissions.

The Results: How Costs Shape Your Wealth

After running the calculations for each scenario over 20 years, here’s what our final corpus looks like:

1. Direct Index Fund (0.20%): ₹6,14,773
2. Direct Active Fund (0.63%): ₹5,83,316
3. Regular Active Fund (1.33%): ₹5,35,785

The difference between the highest and lowest performing options is approximately ₹79,000 – nearly 8 years’ worth of your annual contributions!

Expressed as percentages, the direct active fund investor ends up with about 5.12% less money than the index fund investor, while the regular active fund investor has 12.85% less.

The Compounding Effect: How Small Differences Grow

What makes expense ratios so impactful is their interaction with compounding. Let’s track how the gap widens over time:

• At Year 5:
  • Index Fund: ₹66,768
  • Direct Active Fund: ₹65,939 (difference of ₹829)
  • Regular Active Fund: ₹64,610 (difference of ₹2,158)
• At Year 10:
  • Index Fund: ₹1,73,324
  • Direct Active Fund: ₹1,69,128 (difference of ₹4,196)
  • Regular Active Fund: ₹1,62,524 (difference of ₹10,800)
• At Year 20:
  • Index Fund: ₹6,14,773
  • Direct Active Fund: ₹5,83,316 (difference of ₹31,457)
  • Regular Active Fund: ₹5,35,785 (difference of ₹78,988)

Notice how the absolute difference grows exponentially over time. This happens because each year, the expense ratio is applied to an increasingly larger corpus, and the returns you miss out on also compound.

Performance vs. Costs: The Active-Passive Debate

A common argument favoring active funds is that skilled fund managers can outperform the market, justifying their higher fees. While this can happen, consistent outperformance is rare, especially after accounting for expenses. According to S&P Indices Versus Active (SPIVA) data for India, a significant percentage of actively managed funds under perform their benchmarks over longer periods. Do note, passive funds also have some tracking errors.

That said, some active funds do manage to deliver alpha (excess returns above the benchmark) even after expenses. The challenge for investors is identifying these funds in advance rather than retrospectively. Past performance, as we’re constantly reminded, is not a guarantee of future results.

Role of MFDs

It’s important to acknowledge that Mutual Fund Distributors (MFDs). The trailing fees in regular plans compensate these professionals for their services. Whether these services justify the additional expense depends on your individual needs, knowledge level, and the quality of advice received.

“Some good MFDs can play a useful role in terms of portfolios. Only you can decide whether what you are getting from the MFD is worth the extra TER (total expense ratio).”

The Rise of Index Funds in India

Index funds have gained substantial traction in India over recent years, and for good reason. They offer:

• Low expense ratios
• Broad market exposure
• Elimination of fund manager risk
• Simplicity and transparency

While they won’t beat the market (by definition), they also won’t substantially underperform it. For many investors, especially those with long time horizons, this combination of low costs and market-matching returns presents an attractive option.

Common Questions About Expense Ratios

“Aren’t higher expense ratios justified if the fund performs better?”

In theory, yes. If a fund consistently delivers higher returns (after expenses) than lower-cost alternatives, the higher expense ratio would be justified. However, research consistently shows that expense ratios are one of the most important factors of fund performance, with lower-cost funds generally outperforming most higher-cost funds in the same category over longer time.

“Do expense ratios remain constant?”

No, AMCs may revise expense ratios periodically, though they cannot exceed SEBI’s prescribed limits. Generally, as a fund’s assets under management (AUM) grow, the expense ratio should decrease due to economies of scale.

“Is an active fund always a poor choice compared to an index fund?”

Not necessarily. It is not necessary that an active fund will not give returns more than a passive fund, but if you look at past data, you will see for the majority it is difficult in the long run especially for large caps.

In certain market segments, particularly mid and small caps or specialized sectors, some active management may have more opportunities to add value.

Practical Takeaways for the Indian Investor

Based on our analysis, here are some practical guidelines:

1. Be Expense-Conscious: When comparing similar funds, favor those with lower expense ratios, especially for long-term investments.
2. Understand the Value Proposition: If choosing regular plans, ensure you’re receiving valuable advice and service that justifies the additional cost.
3. Consider Your Investment Knowledge: If you’re confident in making investment decisions independently, direct plans offer significant cost advantages.
4. Look at the Total Cost Picture: Beyond the stated expense ratio, consider any platform fees, transaction costs, or exit loads that might apply.
5. Factor in Tax Efficiency: For equity funds, also consider factors like portfolio turnover and its impact on tax efficiency alongside expense ratios.

Conclusion: The Power of Cost-Efficient Investing

The analysis clearly demonstrates that expense ratios matter significantly over the long term. While a difference of 0.43% or 1.13% might seem trivial in any given year, over decades, these seemingly small percentages translate into meaningful differences in wealth accumulation.

Whether you choose index funds, direct active funds, or regular active funds should depend on your individual circumstances, knowledge level, and need for guidance. There’s no one-size-fits-all answer, but understanding the long-term impact of costs empowers you to make more informed decisions.

For many investors, a balanced approach might work best—perhaps using low-cost index funds as the core of your portfolio while selectively adding active funds in areas where you believe active management can add value.

Disclaimers:

• This analysis is for educational purposes only and not meant as investment advice.
• The calculations assume constant returns and regular investments, which may not reflect real-world conditions.
• Past performance does not guarantee future results.
• Individual fund performance may vary significantly from the assumed 10% return.
• Some active funds may outperform index funds even after accounting for higher expense ratios.
• The value of professional financial advice may outweigh the cost difference for some investors.

I invite you to explore the interactive calculator, run your own scenarios, and see firsthand how expense ratios might impact your investment journey. Don’t forget to share this article with your near and dear ones.