Mutual fund investors like to benchmark mutual fund returns before investing. The cost ratio and tracking error can also affect the returns realized over time, however. For investors who opt for buying straight index funds and exchange-traded funds, these costs and performance distinctions are significant. By knowing how they operate, investors can better determine whether a fund is an efficient tracker of its benchmark and make more informed investment decisions.
What is an expense ratio?
The expense ratio is the percentage that a mutual fund levies on the fund on a yearly basis to run and manage the scheme. It includes fund management costs, operating costs, registrar services and other administrative costs. In an MF app, expense ratio is normally stated as a percentage of a fund’s assets.
In the case of a fund with an expense ratio of 0.50%, for instance, a ₹10,000 investment indirectly costs ₹50 per year (as appropriate, based on the calculation and fund value).
This is a cost that a fund incurs on its own, and is not an investor’s direct cost. Thus, a higher expense ratio may lower the return that can be generated for investors in the long run.
How does tracking error affect returns?
Tracking error measures how closely a fund’s performance follows its benchmark index. It is particularly relevant for passive funds because their objective is generally to replicate the performance of an underlying index.
A lower tracking error indicates that the fund has historically stayed closer to its benchmark. A higher tracking error suggests a greater difference between the fund’s returns and those of the index.
Why lower costs can support long-term returns
Even a small difference in annual costs can have an impact when an investment is held for a long period. This happens because investment returns can compound over time.
Suppose two similar index funds generate comparable gross returns. If one fund has a lower expense ratio and lower tracking error, it may deliver returns that remain closer to the benchmark after expenses.
Comparing funds through an mf app
An mf app can make it easier to compare investment options in one place. Depending on the platform, investors may be able to review a fund’s expense ratio, benchmark, historical performance, risk indicators and portfolio composition before investing.
Investors should avoid selecting a fund solely because it has the lowest expense ratio. A very low-cost fund may still experience higher tracking differences because of other operational or portfolio-related factors.
Direct plans and the cost advantage
Direct plans can be useful for investors who prefer to manage their investments without distributor involvement. Since direct plans generally have lower expenses than regular plans, the difference in costs can potentially improve the amount of money that remains invested.
This can be particularly relevant for long-term investors in passive mutual funds, where the objective is to closely replicate an index rather than rely on active fund management to outperform it.
How to evaluate expense ratio and tracking error together
Expense ratio and tracking error should ideally be assessed together. A lower expense ratio is useful because it reduces the cost deducted from the fund’s assets. Meanwhile, a lower tracking error indicates that the fund has historically managed to replicate its benchmark more closely.
Investors can therefore follow a simple evaluation process:
- Identify the benchmark followed by the fund.
- Compare the expense ratios of similar funds.
- Review the historical tracking error.
- Check performance against the benchmark.
- Consider the fund’s size, liquidity and portfolio structure.
- Match the investment with the desired time horizon and risk level.
This approach can provide a more complete picture than comparing only one-year or three-year returns.
Key takeaway for investors
Lower expenses and efficient benchmark tracking can contribute to better alignment between a passive fund’s returns and its underlying index. Direct plans can offer a cost advantage because they generally carry lower expense ratios than regular plans.
However, investors should consider expense ratio and tracking error alongside factors such as fund size, liquidity, benchmark suitability, portfolio composition and investment objectives. A convenient investment platform can simplify this comparison and help investors review relevant information before making decisions.
Conclusion
Understanding expense ratios and tracking errors can help investors assess the efficiency of passive investments. Lower costs can preserve more of the portfolio for compounding, while lower tracking error can help a fund remain closer to its benchmark. Investors can use these measures along with their financial goals and risk profile when evaluating investment options.
Platforms such as 5paisa can make it convenient to research and manage investments digitally. Before investing, investors should review the scheme’s documents, costs, risks and performance information carefully and make decisions according to their individual financial objectives.
