What Is Expense Ratio In Mutual Funds?

Article Summary

• Expense ratio reflects the charges and expenses such as management fees, administration expenses, marketing, and distribution fees, which are charges deducted from scheme assets

• It isexpressed as the total expenses of the fund divided by the average value of the fund i.e., Average Assets Under Management (AUM).

• Expense ratio can vary from fund to fund but at the same time, it needs to remain below the limits or up to the limits stipulated by SEBI.

• Typically, lower the expense ratio, higher the likely returns and better it may be for investors.

Many of us are aware of the numerous advantages of mutual fund investments. As with any other service, mutual funds incur various expenses while delivering benefits to investors. These expenses play an important role in the final amount you save since the expenses are deducted from the fund’s corpus or Assets Under Management (AUM). In effect, higher the expenses, greater the impact on your returns. This is why investors need to consider the expenses of various mutual fund alternatives before investing in one of them. But how does an investor compare the costs of various investment candidates? That is where the expense ratio, also referred to as Total Expense Ratio (TER) comes in. Let us first answer the question: “What is expense ratio in mutual fund?”

What is mutual fund expense ratio?

Expense ratio in mutual fund reflects the charges and expenses you pay to the mutual fund for managing your investments. It is expressed as a percentage of daily investment value. Since expenses get automatically deducted from the value of your investment, you need to look for information about expense ratio in essential scheme documents such as Scheme Information Document (SID) and Key Information Memorandum (KIM) in the mutual fund’s website or that of the mutual fund regulator, Securities and Exchange Board of India (SEBI).

Expense Ratio formula

You can get the precise answer to the question “what is mutual fund expense ratio?” by knowing the expense ratio formula. This isexpressed as total expenses of the fund divided by average the value of the fund i.e., the total value of all the scheme’s investors or Average Assets Under Management (AUM).

Information about expense ratio in scheme documents, for instance, 2.5%, are relevant for a year. However, this deduction occurs daily and thus, in the case of 2.5 expense ratio, the deduction will be (2.5%/365) or 0.0068%. The daily Net Asset Value (NAV) of the fund is reported after deduction of expenses.

How expense ratio impacts your returns

After answering the question “what is expense ratio in mutual fund?” let us see how expense ratio impacts the returns of your investment by taking a mutual fund investment valued at Rs 10,100 on a particular day. An expense ratio of 2.5% will mean that the investor will pay Rs 0.69 or 69 paise that day. If the average expense remains 69 paise during the 365 days of the year, the investor’s annual outgo will be Rs 252.

Suppose the starting value of the investment was Rs 10, 100, and assuming a 12% annual return, investment valued at Rs 10,100 on the first day of the year will grow to Rs 11,312 by the year-end, assuming no expenses. But on accounting for expenses, it appreciates only by Rs 960 instead of Rs 1,212. This means an effective return of 9.5%. Over long periods, such expenses impact the compounded growth so essential to save large amounts for major financial goals like retirement.

Expense ratio in mutual funds can vary from fund to fund even as they need to remain below limits stipulated by SEBI. Clearly, lower the expense ratio, higher the likely returns and better it is for investors. Alternatively, a mutual fund with a higher expense ratio needs to perform that much better than its peers to justify its expenses.

Expenses Covered by Expense Ratio in Mutual Fund

A more elaborate answer to the question “what is expense ratio in mutual fund?,’ can be obtained by looking at the various expense heads that figure in the expense ratio.

Management fees

These are the costs related to fund management and activities rendered by AMC personnel for operation of the mutual fund.

Administration expenses

Apart from operational expenses, this includes legal and audit expenses.

Marketing and distribution expenses

This includes advertising and marketing expenses, including various types of communications besides commissions for distribution.

Exit load

These are the charges for early redemption by investors as stipulated by the scheme’s conditions.

Brokerage expenses

Such charges arise from the buying and selling of various securities.

Expense ratios for equity and debt funds

The mutual fund regulator, Securities and Exchange Board of India (SEBI), has laid down upper limits of expenses for different categories of funds. For the first Rs 500 crore, it is 2.25% for equity funds and 2% for debt funds. For the next 250 crore, it is 2% and 1.75% for equity and debt funds respectively, with expense ratios declining for subsequent slabs of AUMs.

Expense Ratio’s Implications for Investors

Given the fact that expense ratio impacts returns, investors need to keep in mind the following implications.

• Need for all-round view: Before you invest, besides factors like fit with financial goals, performance track record and risk, account for the expense ratio. It can be a significantly differentiating factor for a lower risk, lower return investment like a debt fund. Same is true for investments that are taxed at income tax rates like debt funds. For instance, Fund of Funds (FoF).

• Lower expense ratio for passive funds and direct plans: Passive investment funds such as index funds and exchange traded funds (ETF) do not involve active fund management. That is why they have lower expense ratios with a mandatory limit of 1%. The same is true for direct plans for any mutual fund like direct mutual fund where expense ratios are lower due to absence of distribution commissions.

• Typically, lower expense ratio for larger funds: From our discussions on mandatory expense ratio limits, it is clear that larger the size of the fund, lower the expense ratio.

To conclude, many mutual fund investors often tend to excessively focus on performance. Time has come for them to take more balanced view that also involves scrutinising expense ratios.

FAQs

Which funds have lower expense ratios?

While direct mutual funds have lower expense ratio due to no distribution costs, lower fund management costs significantly lower expense ratio for exchange traded funds (ETFs) and index funds. Typically, larger the fund size, lower the expense ratio.

How often is the expense ratio charged?

While expense ratio is charged annually, it is deducted from NAV daily till you stay invested.

Where can we find information about expense ratio?

This is present in all scheme documents such as Scheme Information Document (SID) and Key Information Memorandum (KIM) in mutual fund and SEBI websites besides digital mutual fund investment platforms.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.