What is Expense Ratio in Mutual Fund?

Mutual funds (MFs) and exchange-traded funds (ETFs) are slowly but surely making inroads into long-term investors’ portfolios. So, it has become imperative to understand what are the costs associated with investing in these funds, i.e., expense ratios and how these costs impact investing profits. 

But what is expense ratio meaning? Let’s find out.

What is Expense Ratio in Mutual Funds?

An expense ratio is basically the fee charged by a fund manager to manage your investments, expressed in percentage terms. Several costs are associated with managing an investment fund, such as management fees, sales & marketing expenses, administrative costs, registrar fees, transaction charges, custodian fees, and audit fees. In finance parlance, it is called a Total Expense Ratio (TER).

In other words, the expense ratio denotes the per-unit cost of managing an MF/ETF. It is charged on a prorated basis, which means the expense ratio is levied for the amount of time you are invested in the MF. These costs are deducted from your returns daily and are reflected in net asset value (NAV).

To illustrate, if an MF’s expense ratio is 2%.Then, 0.0054% (2%/365) of your total investment will be deducted daily from your investment’s returns.

In India, these expense ratios are fully regulated by SEBI. Investors can easily check a particular fund’s expense ratio from either the AMC’s website or the website of the Association of Mutual Funds in India (AMFI).

Expense Ratio Calculation

The expense ratio is calculated by dividing the total operating costs of the fund by its total assets. Generally, the higher the operational costs, the higher the expense ratio. This is why actively managed funds have higher expense ratios than passively managed funds. 

The expense ratio formula is stated below.

Expense Ratio = Total costs borne by the AMC / Average assets under management (AUM)

Where,

AUM = Fund’s corpus, aka total value of investors’ money in the fund

For example, if an AMC incurs Rs 20 crores expenses and the AUM totals Rs. 2000 crores, then

Expense Ratio = 20 / 2000

Expense Ratio = 1%

This means an investor will be charged 1% of his investment as an expense ratio annually.

Which Costs are Included in Expense Ratio’s Calculation?

Some of the charges that are included in the expense ratio formula are listed below.

Fund Manager’s Fees

About 0.5-1% of the fund corpus goes towards paying the fund’s managers, who spend considerable time in research and hunting for profitable opportunities.  They also need to be compensated for the formulation of an investment strategy, if it is a theme-based fund/ ETF.

Administrative Expenses

An AMC incurs a lot of expenses for operating the fund, including costs related to maintaining records, providing customer support, and maintaining communication.  

12b-1 Distribution Fees

12b-1 fees are charged for compensating brokers who market and sell mutual fund units. It entails the cost of advertising, printing, and mailing of new prospectus and sales literature. 

Legal/ Audit Expenses

Legal expenses may be incurred for meeting the various compliance requirements and processing paperwork related to stock certificates and filings.

Brokerage Fees

This is applicable to cases where you invest in mutual funds through regular plans to compensate the broker for his services. Direct plans do not involve these charges.

Is the Expense Ratio the Same for All Funds?

As mentioned above, the expense ratio is higher for actively managed funds as more expenses are incurred in finding lucrative opportunities within the investment mandate. Additionally, expense ratios also differ across various asset classes. This means an equity-oriented fund will have higher expense ratios than debt schemes and liquid schemes. 

Expense ratios also vary as per the size of the investment corpus. Thus, as the asset size increases, the expense ratio comes down. Thus, the expense ratio is not a static figure; rather it changes over the fund’s term.

However, please note that the expense ratios should fall within the limits prescribed by SEBI under its Regulation 52 related to Mutual funds. We highlight these limits below for actively managed funds.

Exception: Mutual Funds can charge an additional 30 bps if at least 30% of the gross new inflows come from retail investors located in tier 2 and tier 3 cities or 15% of the average AUM (YTD) of the scheme are accounted for by retail investors living beyond B30 cities, whichever is higher.

A maximum of 1.25% can be charged for equity-oriented close-ended schemes and 1% for other close-ended schemes. Index funds, ETFs, and funds of funds (FOFs) can charge up to 1%. The TER for FoFs is restricted to 2x the TER of the underlying funds.

How Does the Expense Ratio Affect Fund Return?

The expense ratio is one of the many factors that affect the returns from a mutual fund. Since the expense ratio is calculated on the investment amount, the higher the expense ratio, the lower your actual returns will be. Here’s an example to help you understand just how the expense ratio affects the final return from your investment. 

Assume you invested a lump sum amount of ₹1,00,000 in an equity mutual fund. The expense ratio of the fund is 1.5%. After about 1 year, the fund value rises to ₹1,08,000, which is a return of 8% per annum. However, the final return from the fund (after deducting the expense ratio) is only ₹1,06,500 [₹1,08,000 – (₹1,00,000 * 1.5%)], which comes up to only 6.5% per annum.

What is a Good Expense Ratio?

There is no ‘good’ expense ratio per se. The general rule is to compare a fund’s expense ratio to its peers and across the investment mandate. As far as costs go, of course, a lower expense ratio is better. But it should be low on an asset-weighted basis.

Let’s understand with a hypothetical example:

Here, XYZ MF offers better returns despite a higher expense ratio, which can be explained by lower AUM.

What is a Low Expense Ratio?

The expense ratio of mutual funds is dependent on the type of fund you invest in. Actively managed mutual funds often have high expense ratios compared to passively managed funds due to the increased expenses associated with administration and management. 

Expense ratios ranging from 0.5% to 0.75% are often considered to be low. Expense ratios of above 1.5% are very high and can quickly eat into your returns. Most actively managed mutual funds have expense ratios ranging from 0.5% to 1.5%, whereas most passively managed funds are in the range of 0.2% to 0.5%. 

Investors often prefer investing in low-expense ratio mutual funds since they have a lower impact on the overall returns compared to funds with high ratios. However, this shouldn’t be the only parameter to choose a mutual fund.

What is the Interest Expense Ratio?

The interest expense ratio is one of the many components of a mutual fund expense ratio. Asset Management Companies (AMCs) routinely borrow funds to invest in market-linked securities. The interest expense ratio represents the amount of interest that the AMC pays on the borrowed amount. 

The higher the amount of borrowing, the greater the interest expense ratio will be. This, in turn, will increase the total expense ratio (TER) of the mutual fund. That said, most mutual funds are only required to disclose their TER and not its components. 

How do Expense Ratios Affect Your Returns?

Higher expense ratios lower an investment’s rate of return, especially over the long term when the compounding effect kicks in. 

Importance of Mutual Fund Expense Ratio

Now that you have understood ‘what is expense ratio in a mutual fund?’, let’s know the importance of expense ratios in your mutual fund journey.

The expense ratio directly impacts the investment outcome of a mutual fund. A lower expense ratio means more of the fund’s returns stay with the investor, maximising their overall gains. Since mutual funds are often long-term investments, investors can enjoy compounding benefits and potentially increase their wealth over the long term by selecting a fund with a lower expense ratio.

Investors can use the expense ratio to compare two mutual funds, especially when they have similar holding patterns. By analysing the expense ratios, investors can assess which funds offer better cost structures and potential returns.

However, the expense ratio shouldn’t be your only deciding factor when choosing a mutual fund for investing. You must consider all the critical factors, such as the past performance of the fund, the fund manager’s experience, and the fund’s holdings, before deciding.

Things to Remember about Expense Ratio

• The expense ratio is the cost you pay to the asset management company for investing in their funds. The asset management company deducts the expense ratio from your total investment; hence, it has a direct impact on your returns.
• The AMC calculates the expense ratio and deducts it from your investment amount every day.
• For this reason, investors prefer funds with a lower expense ratio that will help them accumulate more wealth. But don’t go blindly with the lowest expense ratio. Your mutual fund investment should align with your overall investment goal.
• The expense ratio is directly proportional to the type of fund. As a result, regular funds have higher expense ratios than direct funds.
• Expense ratios have a higher impact on debt funds because these funds have relatively lower returns.
• While investing, selecting a fund with a large AUM may help lower the expense ratio and vice-versa.

Bottom Line 

An investment scheme doesn’t become a suitable choice solely because it has a low expense ratio; such a scheme must also deliver good returns.

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