Exchange Traded Funds (ETFs) are a popular investment option for investors looking for a simple, low-cost way to diversify their portfolios. These funds track the performance of a specific index, like the Nifty 50 or Sensex, and can be bought and sold on stock exchanges, just like shares.
When you invest in ETFs, you are not just putting your money into a diverse basket of assets, you are also paying a fee, known as the total expense ratio (TER). Let’s break down what expense ratios mean and why this fee matters for your investment returns.
What is the expense ratio in ETFs?
The expense ratio in exchange traded funds is the annual fee charged by the fund. It is expressed as a percentage of the total assets under management (AUM). These costs include administrative fees, management fees, and marketing and distribution expenses.
Why do expense ratios matter for your investment returns?
The primary reason the expense ratio is important is its direct impact on your ETF returns. Even small differences, such as 0.5% versus 1%, can significantly reduce your returns over time. Take a look at an example.
Let’s say you invest ₹5,00,000 in an ETF with an annual return of 10%.
- If the expense ratio is 1%, your net return will be around ₹45,000 after a year.
- If the expense ratio is 0.5%, your net return rises to ₹47,500.
Expense ratios don’t just reduce your returns, they grow larger as your portfolio grows. For example, a 1% expense ratio on a ₹10 lakh portfolio costs ₹10,000 annually, but on a ₹50 lakh portfolio, it rises to ₹50,000. This increase can significantly impact your long-term gains and highlights the importance of choosing ETF investments with lower expense ratios to maximise your returns.
Other factors that matter for your investment returns from ETFs
While the expense ratio is a key cost metric, it’s not the only one that can influence your ETF returns. Other aspects also play a role in how your portfolio performs:
- Fund performance: A fund’s ability to track its benchmark accurately impact the returns. Even with a low TER, an ETF that experiences tracking errors might deliver lower-than-expected results.
- Asset allocation: The mix of equities, debt, or other assets in your portfolio could affect its overall performance. If your portfolio is not well-diversified, it may expose you to higher risks or limit growth opportunities.
- Market volatility: Market fluctuations may affect your portfolio’s value, particularly in the short term. Long-term investors could benefit from staying invested during volatile periods, as markets historically recover and continue to grow over time.
- Dividend yield and reinvestment: ETFs holding dividend-paying securities can generate regular income. Efficient reinvestment of these dividends enhances compounding returns.
- Currency risk: For ETFs investing in foreign assets, currency fluctuations can either boost or reduce returns, depending on exchange rate movements.
When choosing the best ETFs to invest in, focus on affordability and performance reliability to make sure your portfolio delivers strong returns over the long term.
Key takeaways
Understanding the expense ratio of ETFs is important because it directly affects your investment returns. A reasonable expense ratio ensures that your costs stay low and leaves more of your money to grow over time.
Note that an ETF’s historical performance, the consistency of its tracking error, and the reliability of the underlying index are just as important. Moreover, don’t forget to check liquidity, fund house reputation, and any additional costs like brokerage fees. Most importantly, make sure the ETF matches your financial goals and investment strategy.
