A fund house has a lot of expenses towards managing the fund. For instance, the management team tracks the performance of the underlying assets of the portfolio. The fund manager chalks out the strategy for investment.
The total cost incurred towards such expenses is called the expense ratio and it is expressed as an annual percentage of the AUM of the fund. For example, if the AUM of a fund house is INR 2000 crores and the expense ratio is 1.5%, the total expenses incurred by the fund is INR 30 crores and the fund will charge you 1.5% of the investment value for managing your money.
When it comes to investing in a mutual fund, the expense ratio plays a critical role. Here’s what you need to know about expense ratio while deciding on an investment.
How Does Expense Ratio Impact You?
The expense ratio impacts you in several ways.
A higher expense ratio will ultimately reduce your long-term returns. If you are keen on maximizing your returns, make sure to pick a fund with a lower expense ratio. There’s also a popular myth that a higher expense ratio is an indicator of a better-managed fund. However, the quantum of the expense ratio has no bearing on its performance as a fund with a lower expense ratio can give you better returns than a fund with a higher expense ratio.
You can also use the expense ratio to compare mutual funds before you decide to invest. For example, the expense ratio of a direct plan is less than a regular plan. In the case of regular plans, commissions to the tune of 0.5% to 1.5% for agents are borne by the investor. But unlike regular plans, there are no agents or intermediaries involved in direct plans. The investor can directly invest in a mutual fund. As a result, the fund house doesn’t need to pay any commissions to the distributors for selling direct plans. This reduces the operating expenses of a direct plan significantly, leading to a lower expense ratio and higher returns.
What are the various charges included in expense ratio?
The following expenses form part of the expense ratio:
- Management Fees:
Mutual fund managers are highly skilled professionals who utilize their business acumen to chalk out the appropriate investment strategies. These strategies are geared towards providing high returns to the investors. As a result, management fees paid to such managers are part of the expense ratio. Typically, the management fees account for 0.50% to 1% of the fund’s total assets.
- Distribution Fees:
Certain mutual funds also charge distribution fees. This is used towards the annual marketing and distribution of a particular fund. It is also referred to as the 12b-1 fee. The purpose of this fee is to pay commission to the intermediaries who help in selling the units of a mutual fund.
- Administrative Costs:
Looking after the administration of a mutual fund is no child’s play. There’s a significant amount of effort required for maintaining appropriate records, emails, and other documentation. Expenses towards such activities are the administrative costs and form part of the expense ratio.
- Exit load:
Certain funds also include the exist-load as part of the expense ratio. Exit load is the amount that an investor needs to pay in case of a premature exit from the fund. It is payable on the total investment of an individual and is usually between 2 to 3%.
How is expense ratio calculated and deducted?
For most funds, the expense ratio is deducted from the total revenue of the fund, prior to distributing the returns to the investors. A common misconception is that the expense ratio is deducted right at the time of purchasing the units of a mutual fund. In practice, the deduction on a daily basis after taking into account the expenditures per day.
The annual expenses ratio specified by the fund is divided by the total number of trading days in a year. The resulting number is applied to the closing gross NAV. For example, if there are 252 trading days in a particular year and the expense ratio is 1%, the daily expense is calculated by dividing the trading days by the expense ratio which is 0.0039%. This percentage is charged on the closing gross NAV of a mutual fund.
If your investment amount in a fund is INR 20,000 with a 5% return and an expense ratio of 1%, you need to pay INR 200 towards the management of the fund. The total returns that you will receive will be:
( INR 20,000 + 5% of INR 20,000 ) – 1% of INR 20,000 = INR 19,1900
Are there any limits to the expense ratio?
SEBI, the mutual fund regulator, has prescribed the limits of expense ratio under the SEBI Mutual Fund Regulations. According to these regulations, the expense ratio of open-ended equity-oriented and open-ended non-equity-oriented schemes is as follows:
- For the first INR 100 crore of the average weekly total net assets — 2.5%,
- For the next Rs.300 crore of the average weekly total net assets — 2.25%
- For the next INR 300 crore of the average weekly total net assets — 2%
- Remaining Assets Under Management — 1.75%
In the case of debt funds, the total expense ratio is capped at 2.25%. For equity-oriented close-ended or interval schemes, the total expense ratio is capped at 1.25%. Exchange-Traded Funds and Funds of Funds enjoy the lowest expense ratio of 1%.
The expense ratio can be a handy tool to determine which mutual fund is a better investment option. Having said that, it is equally important to understand your investment goals and risk appetite before you part with your hard-earned capital.