Expense Ratio: Should you even consider it

There are various factors that you should consider before investing in mutual funds. One of them being, expense ratio. The general rule is lower the better and hence funds with lower expense ratio are expected to give better returns. Nevertheless, it may not hold true always.  

The expense ratio is the fees charged by the mutual fund companies to their unitholders. This charge includes all the operating cost required for running the fund including administrative cost, compliance cost, fixed overhead charges and not to forget fees for asset management.
  
These are expressed as a percentage of net asset value (NAV) and are deducted on daily basis as a percentage of NAV. The daily NAV that we get is only after deducting these expenses. These are recurring expense and keep on changing. Nevertheless, the market regulator, SEBI has kept a limit on the maximum expense ratios that schemes can charge.  
Our study of more than 150 equity diversified funds, excluding index and Exchange Traded Funds that are designed to have a lower expense ratio, shows that there is no direct relationship between expense ratio and return generated by the fund. What is important is that this is applicable for the entire period, from one month return to 5-year returns.
  
On the contrary, there is a positive relationship between expense ratio and returns generated between one month and three years. Although there is a negative correlation between expense ratio and five-year return. However, all the correlations are insignificant.  

Going one step further, we tried to test the significance of a correlation between expense ratio and returns generated at different time interval at 95 per cent of confidence level, we again found it insignificant. Even running a regression analysis, to understand the relationship between expense ratio and returns we found it to be statistically not significant. Therefore, expense ratio does not determine either long-term returns of the fund or short-term returns.  

Hence, while selecting a mutual fund scheme one should keep a close eye on fund’s expense ratio and it should be a deciding criterion.