What matters to you the most when you invest in mutual funds? Most investors would say that returns are what they look for, regardless of the time they remain invested in the market. It is quite natural, as you want to grow your wealth over time. That’s why you take time to compare top-performing mutual funds, study market trends, and search for the best opportunities. However, costs are one of the biggest factors that affect wealth creation in the long term, and this often goes unnoticed.

When you evaluate the returns in a single year, a difference of 1% apparently seems insignificant. However, when you continue with your SIPs for decades, this difference can translate to lakhs.

In this blog, we have demonstrated how a small SIP of just INR 5,000 per month could create additional wealth worth INR 14 lakh through consistency and discipline.

Why the return you see is not always the return you keep

It’s easy to assume that the returns you see for a mutual fund are exactly what you will earn. In reality, various other costs can affect the return that a fund generates and the wealth you actually receive.

The role of expense ratio

An expense ratio is associated with every mutual fund. This is the fee covering costs like fund management, administration, operational expenses, and other costs involved in running the scheme. You might feel that these expenses appear small when calculated annually. But in the end, they are deducted from the assets of the fund. As a result, they directly influence your returns.

Let’s assume a situation where your mutual fund generates a 12% annual return. Being a regular fund, it involves a 1.5% expense ratio. The actual return for your portfolio, therefore, comes to 10.5%. Although it’s easy to overlook the small expense ratio, the difference can significantly contribute to the overall wealth over the years.

The power of compounding works both ways

Compounding helps to capitalise on your returns, which generate additional wealth. The snowball effect continues over time. However, investors often overlook the fact that costs compound as well.

So, when your returns are reduced by a higher expense ratio every year, the impact affects the future growth potential. You eventually lose out on the growth that the deducted money could have generated.

The longer your investment horizon, the greater the impact these small differences create in your annual return. Over 20 to 25 years, this gap can become surprisingly large.

Direct vs regular mutual funds

The choice between direct and regular mutual funds defines one of the common differences in returns that you gain over the year.

What are direct funds?

Direct mutual funds are those funds that you can purchase directly from the AMC (asset management company). The process does not involve an intermediary like a distributor or broker. This means no commissions are involved for the intermediaries. That’s why the expense ratios associated with direct mutual funds are lower compared to the regular ones.

As the expense ratio is lower, a larger portion of the returns generated from the fund remains in your portfolio. This can significantly contribute to a higher corpus over long periods, even when both the funds have the same underlying portfolio.

If you are comfortable researching and selecting funds independently, direct mutual funds can help you with a cost-effective route to create long-term wealth.

What are regular funds?

Investors purchase regular mutual funds through distributors, brokers, financial advisors, or investment platforms. Some of these platforms often offer advisory services. The commission that is paid to intermediaries is included in the expense ratio, which makes this cost slightly higher than that of direct plans.

When you compare direct vs regular funds, it’s crucial to understand this trade-off. While you may receive additional support and guidance with professional assistance through regular plans, direct plans help you achieve cost efficiency.

The INR 14 lakh difference explained with real numbers

Let’s take some realistic figures to understand how a subtle difference in expense ratio can amount to a difference as high as INR 14 lakhs over a long-term horizon.

We assume that two investors contribute INR 5,000 per month through an SIP for 25 years. Both choose the same mutual funds, but the first investor opts for a direct fund, while the second decides to go with a regular mutual fund.

The overall investment during this time horizon comes to INR 15,00,000. The return from a direct scheme is assumed to be 12%, and that from a regular fund would be 11%, considering an expense ratio of 1%.

Now, using standard SIP calculators, let’s find the returns.

Direct fund at 12% annual return

Approximate corpus after 25 years is INR 94 lakh.

Regular fund at 11% annual return

Approximate corpus after 25 years is INR 80 lakh.

The difference in the final corpus is approximately INR 14 lakh, even when both investors contributed exactly the same amount every month. A difference of just 1% annually can help you accumulate approximately INR 14 lakh more over 25 years.

What the numbers are actually telling you

The difference of INR 14 lakhs was not created overnight. In the early years, the two portfolios had a relatively small gap. However, the effect of compounding started to magnify the difference in the following years.

The returns generated each year further compounded to create additional wealth in the subsequent years. The gap widened over the years, and in the long term, it became impossible to ignore.

That’s why experienced investors often prioritise factors that are within their control. These include costs, consistency, and investment horizon. The verdict is that small differences in costs can make significant differences over time.

How to compare funds before investing

While deciding the mutual fund you would invest in, a practical approach is to look beyond the highest recent returns. The cost and fund structure also makes a visible difference in your overall returns. Experienced investors strategically compare funds using the following approaches before they put their money into the schemes.

1.    Looking beyond recent returns

Often, investors feel tempted to choose funds with exceptional returns for one or two years. However, a short-term return doesn’t justify the long-term consistency of the fund. This is because markets move in cycles. A fund that delivered strong returns recently may underperform in subsequent cycles.

This explains why you need to evaluate the consistency of performance for the last five to ten years. Assess common factors like the quality of the portfolio and risk management. It’s the long-term performance across different market conditions that should matter more to investors.

2.    Understand costs and fund structure

The overall outcome of your investment is largely influenced by expense ratios, as explained earlier. A slight difference in structure and expense ratio can amount to a substantial difference over time. Therefore, it’s logical to choose direct mutual funds through digital platforms to preserve a greater part of your gains.

3.    Use tools to make informed decisions

Investors today can access a wide range of tools like SIP calculators on popular platforms like Dhan. These tools help them simplify their research. Before investing, you can even compare mutual funds on these platforms based on different parameters like historical performance, risk metrics, expense ratios, investment goals, and composition of their portfolio.

Should every investor choose direct funds?

The answer depends on the understanding of the markets for investors.

If you are confident enough to conduct your own research and make independent investment decisions, you may consider going for direct mutual funds. Experienced investors often prioritise cost efficiency.

They spend time understanding the market and evaluating schemes. From time to time, they also review their portfolios. If you’re investing over the long term, lower costs can eventually translate into a larger portfolio over time.

When regular funds may still be useful

Not every investor might be in a position to manage their investments independently. Particularly, beginners prefer professional guidance and need assistance with goal planning and portfolio reviews. In these circumstances, the additional cost associated with regular funds is justified by the support they receive.

It helps young investors make better financial decisions so that they remain disciplined even when markets are volatile. As an investor, your goal is to evaluate whether the value exceeds the additional cost you are shelling out.

Conclusion

Investing in a mutual fund with the highest returns doesn’t necessarily define successful investing. You must understand the factors influencing how these returns actually help you grow your portfolio. That’s why investors must look beyond fund selection or timing the market. It’s about maximising the effect of compounding and choosing cost-efficient funds. When you build a portfolio, focus on factors that are within your control. Maintain consistency and discipline with your SIPs and evaluate costs carefully as you compare different mutual funds. Small choices made consistently over the years can contribute to a resilient portfolio as you build wealth.