Mutual Funds Beginner

Everything you need to know about expense ratio

expense ratio

Any service or product you avail or purchase comes at a cost. And mutual funds are no different. Fund houses or Asset Management Companies (AMCs) usually offer a wide variety of mutual funds. Experts from the company manage these funds. When managing a fund, there are many operating expenses involved. The mutual fund expense ratio is a share of the cost that investors have to take on. Learning all about them will you help you find a fund that suits your needs.

What is a mutual fund expense ratio?

The expense ratio is a percentage. It refers to the amount you’re giving the AMC as fees for managing your portfolio. It’s the per-unit cost for managing and running the mutual fund.

The expense ratio differs from one mutual fund to the next. It’s calculated as a percentage of the daily investment value. Usually, you don’t actually pay for this separately.

The formula for expense ratio

To calculate the expense ratio, all you need is this simple formula:

Expense Ratio = Total costs the mutual fund bears/Assets under management (AUM)

Here, the numerator is the total expense the company incurs to manage your fund. The denominator is a sum of all the assets under management.

Calculating expense ratio

Expense ratio calculations work as follows: The lower the assets, the higher the mutual fund expense ratio and vice versa.
Let’s assume a hypothetical mutual fund with an AUM of ₹1,000 crore with expenses of ₹20,000 crore. Thus, the expense ratio is ₹20,000 crore/₹,1,000 crore = 2%.

So, every investor would have to pay 2% per year as the expense ratio.

However, you will not actually pay it. Rather, it’ll be deducted every day during your period of investment.

Example of expense ratio in action

Extending the example above, if you invest ₹10,000 in a mutual fund with an expense ratio of 2%, then 0.0054% (2%/365) will be deducted from the investment value every day.

This per-day levying of the expense ratio ensures that you are not overcharged. You only pay for the period of your investment—however long that is.

Investing in the lower expense ratio mutual funds is what you want to look to do. Because they deduct a lower percentage of your returns.

Components of expense ratio

Many charges apply to a mutual fund. The charges are detailed in a statement every six months. They are invariably as follows:

Brokerage fees: Mutual funds can be either direct or regular. Direct mutual funds process transactions themselves, while AMCs hire brokers to process them for regular mutual funds. So, regular mutual funds come with brokerage fees included in the expense ratio.

Management fees: Management fees, which usually are 0.5–1% of the total assets, help pay the portfolio managers who look for investment opportunities.

  • Entry load: These are charges that investors pay while joining a mutual fund. While different mutual funds and AMCs charge different entry percentages, recent Securities and Exchange Board of India (SEBI) regulations abolished entry load.
  • Exit load: This is a charge that individuals who choose to withdraw from a mutual fund owe. The exit load is usually 2–3% of an individual’s total investment. It is essentially a tool to discourage people from pulling out of the fund.
  • 2B-1 fee: While creating a fund, one also needs information to share with the masses. This fee helps cover the cost of creating that information. They are essentially charges for promoting the relevant mutual fund.

Maintenance expenses: These are the total costs for ensuring smooth administrative operation. These include customer support, investor record maintenance, etc.

Additionally, the expense ratio calculation also takes into account the maturity and the duration of the mutual fund.

What are the expense ratio limits?

SEBI has imposed a limit on the Total Expense Ratio (TER) chargeable by mutual fund companies. See the tables below for details.

SchemeMaximum TER
Fund of funds (FoFs) that invest in liquid funds, index funds, or Exchange Traded Funds (ETFs)1.00%
FoFs that invest in actively managed funds other than equity schemes2.00%
FoFs that invest in actively managed equity schemes2.25%
ETFs/Index Funds1.00%
Other than close-ended, equity-oriented/interval schemes1.00%
Close-ended equity-oriented/interval schemes1.25%

Table 1: The limits for close-ended/passively managed mutual funds

AUM (in Crores)TER limit (equity schemes)TER limit (other than equity schemes)
₹10,001– 50,0000.05% (reduces with every ₹5000 cr. increase in daily net assets)0.05% (reduces with every ₹5000 cr. increase in daily net assets)
₹5001–10,0001.5%1.25%
₹2001–50001.6%1.35%
₹751–20001.75%1.5%
₹501–7502.00%1.75%
₹0–5002.25%2.00%

Table 2: The limits for actively managed mutual funds.

For any remaining assets, the TER is 1.5% (equity schemes) and 0.8% (other than equity schemes).

The importance of mutual fund expense ratio

While you think you may understand expense ratios by now, the following points highlighting its importance may make you understand it more clearly.

  • The mutual fund expense ratio is one of the deciding factors when you’re trying to choose between two similar mutual funds in which to invest.
  • A higher mutual fund expense ratio doesn’t mean it’s a better mutual fund. Conversely, funds with lower expense ratios, too, can produce equal or better returns.
  • A regular fund’s expense ratio is higher than that of a direct fund as investing through distributors in regular ones sees commission becoming a part of the expense ratio.
  • Finally, expense ratios impact debt funds more. Because the relatively lower returns aren’t good enough to beat inflation.

Impact of expense ratio on mutual fund returns

Let’s say you invest the same amount per month in two funds with expense ratios of 1.83% and 0.5% with an investing period of 60 months. The maturity amount for the direct fund is higher due to the lower expense ratio of 0.5%. Moreover, the difference in returns over five years can further compound as the years go by. Another thing to remember is that the mutual fund expense ratio contribution grows as your investment value grows.

Things to remember about expense ratio

  • Mutual fund expense ratios can be used to compare mutual funds.
  • Don’t blindly go after the lowest expense ratio mutual funds. Rather, align your investment goals with the mutual fund.
    Funds with higher AUMs are likely to have lower expense ratios as management costs are distributed amongst a higher number of investors.
  • Adopting a passive approach to investing, such as investing in ETFs and index funds, will result in you spending less on the expense ratio.

Conclusion

All in all, expense ratios are an important factor for choosing which funds you want to invest in. All you need to ensure is that your investment goals align with the fund that you choose.

FAQs

What is expense ratio formula?

The expense ratio formula for mutual funds is:

– Expense Ratio = (Total Expenses) / (Average Assets Under Management)

It calculates the percentage of your investment that goes towards fund management and operating costs.

Does Net Asset Value (NAV) include a fund’s expense ratio?

No, Net Asset Value (NAV) of a mutual fund does not include the fund’s expense ratio. The NAV represents the fund’s assets minus its liabilities, while the expense ratio is a separate fee deducted from the fund’s assets.

What is good expense ratio?

A good expense ratio for a mutual fund is typically low, ideally below 1%. It indicates lower costs for investors, allowing more of their returns to be retained.

What is an expense ratio?

An expense ratio is a percentage representing the annual costs associated with managing a mutual fund. It includes management fees, administrative expenses, and other operational costs, impacting investor returns.

Is a high expense ratio good?

No, a high expense ratio is not good for investors. It means higher costs and can eat into investment returns. Lower expense ratios are generally preferred for better long-term gains.

What is expense ratio in SIP?

Expense ratio in a SIP (Systematic Investment Plan) is the annual fee charged by a mutual fund for managing the SIP investments. It’s expressed as a percentage of the total assets under management (AUM) and covers fund management, administrative, and other operating expenses. Lower expense ratios are generally preferred as they reduce the cost burden on investors.

Disclaimer: Investing in mutual funds is subject to market risks. Please read all scheme-related documents carefully before investing. Potential returns from a mutual fund product are not guaranteed. Past performance is not indicative of future results. None of our articles are intended to and should be considered investment/financial advice from CoinSwitch.

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