What Is Expense Ratio In Mutual Funds & How It Is Calculated?

Mutual funds

The expense ratio in mutual funds is the annual fee charged by fund houses to manage the funds of the investors. It serves as a measure of a fund’s operating cost compared to its assets and helps to decide whether a fund is profitable or not.

For instance, an individual invests Rs. 20,000 in a mutual fund with an expense ratio of 1%. In that case, they will pay Rs. 200 as an operating fee annually. Now, if the same person chooses to invest the equivalent amount in a mutual fund with an expense ratio of 2.5%. In such a case, they will pay a higher operating fee of Rs. 500, which will lower the returns.

Since operating expenses impact returns, investors must find out about expense ratio before making an investment decision. This post breaks down all the details of expense ratio – its components, significance, expense ratio limit by SEBI, returns and how it is calculated. Read on!

What are the Components of Expense Ratio?

In general, the mutual fund expense ratio is inclusive of numerous crucial charges to operate a mutual fund scheme. Most fund houses recover those costs from their investors on a daily basis. The costs included under the expense ratio in a mutual fund are as follows:

Administrative Cost: Fund managers incur this cost to run a fund. Typically, it includes the cost of information emails, customer support, and communications. 

Management Fee: Generally, fund houses appoint fund managers to manage their mutual fund schemes. The said fee is paid to compensate portfolio managers. In most cases, the annual management fee is 0.50% to 1.0% of funds’ assets. 

Brokerage Fee: The brokerage fee is charged by the Asset Management Company (AMC) if the investor opts for regular mutual funds. The AMC will hire brokers to manage, buy and sell shares. This is an add-on fee to the expense ratio. On the other hand, if the investor opts for a direct mutual fund, where the buy-sell transaction is not actively overseen by a broker, no brokerage fee will be charged. 

12B-1 Fee: The 12B-1 fee is another component of the expense ratio. It is the amount spent towards the promotion of a mutual fund. It includes spreading information and awareness about a particular mutual fund.

Entry Load: Entry load is the amount to be paid by the investor at the time of joining a mutual fund. Depending on the mutual fund, different entry loads are charged. This can directly impact the mutual fund returns.

Exit Load Exit load is the amount paid by the investor in case they decide to exit the mutual fund. About 2%-3% is charged on the total investment. Exit load is charged to prevent investors from withdrawing from mutual funds. 

Also Read: What is employer stock ownership plan (ESOP)

What Is a Good Expense Ratio?

A good expense ratio is considered to be between 0.50% – 0.75%. An expense ratio greater than 1% is considered a high expense ratio. In other words, the lower the expense ratio, the better the chances of getting a better percentage of the mutual fund returns. 

Expense Ratio Limit by SEBI for Different Schemes

While different mutual fund schemes come with varying costs, the total expense ratio (TER) is levied as per SEBI regulations. Notably, the regulatory body has laid down different norms for equity and non-equity-oriented schemes. Below is the ceiling on different schemes:

Impact of Mutual Fund Expense Ratio on Returns

The expense ratio of a fund helps to understand how much an investor will have to shell out to get their investment portfolio managed by professionals.

Investors have to pay an expense ratio till the time they are invested in a specific mutual fund. Hence, a high mutual fund expense ratio impacts returns on investment negatively. In the long run, this can erode investors’ potential earnings. Consequently, investing in mutual funds with a low expense ratio can aid in maximizing returns. 

Let’s say a mutual fund has a total expense ratio of 2% and generates a profit of Rs. 700. So, the total returns on investment will be Rs. (700 – 14), i.e., Rs. 686. 

Again, a mutual fund with a total expense ratio of 1.5% generates a profit of Rs.700. This means at the end, an investor receives Rs. (700 – 10.5), i.e., Rs. 689.50. Hence, a low Total Expense Ratio (TER) reflects higher profitability. However, a high expense ratio in a mutual fund does not always indicate low returns since the earnings also depend on the funds under management. 

Hence, TER helps investors compute and decide which mutual investment fund will be more profitable and help achieve investment goals faster. 

Based on this operating fee, one can easily decide whether or not the mutual fund will be a lucrative investment instrument. Since the investment market is subject to risks, it is crucial for investors to proceed cautiously. But typically, choosing a low-cost index fund can help maximize one’s portfolio value. For instance, NAVI Nifty 50 Index Fund scheme comes with an expense ratio of 0.06%. The low mutual fund expense ratio can prove helpful in protecting returns from lowering.  

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

Notably, besides finding out the impact on returns, the expense ratio in a mutual fund is crucial for several other reasons.

Also Read – 10 Best Mutual Funds To Invest In India with High Return [2022]

Significance of Expense Ratio in Mutual Funds

Helps Investors Ascertain the Payable Amount

The expense ratio in MF allows investors to gauge how much money they have spent on fund management. Notably, a fund’s expense ratio increases in a proportion equivalent to the increase in the investment value. Gaining an insight into this idea can help investors determine beforehand what to expect when their investment increases or decreases. 

Helps Decide the Merit of Direct Plans

Usually, direct plans accompany a lower expense ratio than regular plans. This is primarily because of the absence of any third-party involvement in the investment process. In turn, it helps to choose a more cost-effective alternative. However, investors must also factor in other crucial details of the fund like its performance and risk-reward profile before deciding the merit of the funds in question.

Helps Understand the Impact on Returns

A higher expense ratio in MF eats into investors’ returns on investment. Hence, finding out about it beforehand helps determine how much of their returns on investment will erode in the long run. This helps to align investment goals with their choice of investment instrument and streamline the overall process better.

How is Expense Ratio Calculated? 

The expense ratio in Mutual Fund is the % of the average weekly net assets of a fund. It can be calculated using this formula: 

Expense Ratio = (Total operating expenses/Total value of fund assets) x 100

For example, it costs nearly Rs. 10 lakhs to manage a fund in a year. The fund holds Rs. 10 crores in assets. So as per the expense ratio formula, the ratio would be –

= Rs. (1,000,000 / 100,000,000) x 100

= 1%

Also read: What are growth funds: Benefits, types, risks and who should invest

Final Word

It is important for investors to know about the mutual fund expense ratio and its significance. It helps to make wise decisions while investing in mutual fund schemes. It also helps to understand how much your fund and fund house choice impacts overall returns on investment. Choose mutual funds with a lower expense ratio and talk to your fund manager about the entry and exit load before investing. Navigate to Navi Mutual Fund to jumpstart your investment journey. 

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

FAQs on Expense Ratio in Mutual Funds

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

This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.