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What Is Expense Ratio, And Why Should Mutual Fund Investors Know About It?

All You Need to Know About NAV in Mutual Funds

Professional Tax In India – 2021 Tax Slab Rates & Applicability

While investing in mutual funds, apart from conducting a risk-return analysis, individuals must take note of the factors that may affect their total earnings. One such crucial point is the expense ratio involved. 

Expense ratio is the annual fee charged by fund houses to investors, as a percentage of their total assets, to manage funds. Typically, it determines how much of a fund’s assets are used to meet operating and administrative expenses.

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 operating fee annually.

Now, 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 to a great extent, investors must make it a point to find out about it before making an investment decision.

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 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. 

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:

Type of Scheme TER limit
Equity-oriented close-ended/interval schemes1.25 
Funds other than equity-oriented close-ended/interval schemes1.00
Passive funds – Exchange-traded funds or index funds 1.00
Funds of funds that allocate corpus in equity-oriented and actively managed schemes 2.25
Funds of funds that allocate corpus in non-equity-oriented and actively managed schemes2.00
Funds that allocate assets into liquid funds, ETFs, and index funds1.00

Impact of 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 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 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 expense ratio can prove helpful in protecting returns from lowering.  

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

Significance of Expense Ratio

It helps ascertain how much an investor will pay to a fund house

Expense ratio 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. 

It 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 to understand the impact on returns

As discussed, a higher expense ratio 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. 

Expense Ratio Formula 

Expense ratio is the % of 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%

Final Word

Possessing a fair idea of these aspects of the expense ratio and its significance allows making a wise decision when comparing mutual fund schemes. It also helps to understand how much your fund and fund house choice impacts overall returns on investment and more. 

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Frequently Asked Questions

What is the difference between management fees and expense ratio?

A management fee is the cost investors have to pay to avail professional assistance to manage their funds. On the other hand, the expense ratio includes management fees and all other expenses that a fund house could incur to operate a specific fund.

What is annual gross expense ratio?

It is the amount paid for management fees and interest. 

What is the TER limit on debt funds?

The Total Expense Ratio limit on debt funds is 2%.

What is the difference between gross and net expense ratio?

The following table highlights the significant differences between gross and net expense ratios. 

Gross Expense RatioNet Expense Ratio
It is the portion of total mutual fund assets that are used to keep the fund afloat.It is the portion of total mutual fund assets used to cater towards the fund’s operating or management expense. 
Examples of gross expense ratios include expenses made on management, advertising, and administration. Examples of net expense ratios include waivers, trading costs, and reimbursement.

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