Should you invest in a fund because it is cheap?



Well, with rising prices and a slow economy, everybody wishes to get things they want easily and at a cheap price. Even the investments are not spared in this matter. So, should you invest in a fund just because it is cheap? Let’s find out.


Firstly, you need to understand the term –


Expense Ratio:

The expense ratio includes all the expenses incurred in fund operation such as registrar and transfer fees, fund management fees, sales commission and other related costs.


A fund’s NAV (Net Asset Value) is calculated only after accounting for all the expenses on a daily basis. An annual expense ratio of one percent signifies that one percent of your portfolio goes towards paying the expenses annually.


It is the expense ratio that affects the portfolio returns. For instance, a one percent expense ratio on investment of Rs.1 lakh appreciates to Rs.1.69 lakh over a period of five years at 12% per annum. In fact, it will yield Rs.7,455 more than a fund having a two percent expense ratio.

Since April 2019, SEBI has reduced the upper limit for expenses.


The expense ratio of open-ended equity has been capped at 2.25% while it is 2% for the rest. The expense ratio is subject to asset size; more the asset size lesser the fund can charge.


Some funds still have a higher expense ratio specified by SEBI and some funds are revising it upwards. As an investor, you should adopt a strategy based on the category of the fund.

Have a look at what you can consider as an investor.


1. Large-cap equity funds

While most large-cap funds are charging anywhere between 1.69 to 2.67%, some are charging much higher. Also, all large-cap funds having an asset size of Rs.10,000 crore are charging below 2%.


To invest in a large-cap fund, always choose a good performer with a large asset. This will help bring down expenses. Also, owing to good liquidity form in large-cap space, it will not affect the way it performs in the market.


2. Index funds

As per regulations, Index funds and exchange trade funds (ETF) can not charge more than 1% of expense ratio annually. You can choose an index fund that is cheap and has a low tracking error.


Note: Exchange trade funds with a 0.2% expense ratio have found to be much cheaper than the traditional index funds.


3. Debt funds

Debt funds offer relatively lower gains. Its expense ratios are also lower. Liquid funds, on an average, are charging about 0.29% against the regulatory cap of 1%.


While investing in short-end debt funds, always look beyond returns. Instead, you should at the portfolio construction. Funds with higher expense ratios take higher portfolio risk to cover-up expenses.


4. Mid-cap and small-cap

Mid-cap and a small-cap fund has a divergent performance. For these funds, outperformance matters more than the expenses. Therefore, invest in funds having superior performance than with those having a lower expense ratio.


If you had invested in small-cap funds last year, you could have earned returns anywhere between -19% to +22%.


Conclusion

Be it debt or equity funds, expense ratio does matter. Although a fund with a large size can bring down expense ratio, the strategy can backfire in case of small or midcap funds.


Therefore, it is recommended that you look for value in your funds rather than simply going in for a cheap fund.

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