An expense ratio is the annual cost of managing and operating an investment fund, like a mutual fund or exchange-traded fund (ETF). It’s expressed as a percentage and represents the fees and expenses investors pay. A lower expense ratio is generally better, as it means lower costs for investors.
What is the Expense Ratio?
The expense ratio is the percentage that denotes the amount of money you are paying to the AMC as a fee to manage your investments. In other words, it is the per-unit cost for running and managing the mutual fund. The expense ratio differs from one mutual fund to another. You do not pay for this expense ratio separately; it is calculated as a percentage of the daily investment value.
For example, if you invest Rs 5000 in a mutual fund with an expense ratio of 2%, then (2%/365=0.0054%) will be deducted from the investment value each day. The per-day levying of the expense ratio ensures that you only pay for the period you stay invested. But this deduction of the expense ratio is lowering your returns by a tiny amount every day. Hence, a mutual fund scheme with a lower expense ratio is more beneficial to you because it takes away a lesser portion of money from your returns.
Expense Ratio Formula
Expense Ratio=Total expenses/Average AUM
- Total expense: The costs incurred by the AMC mentioned above like fund manager’s fee, marketing, and distribution expenses, legal/audit costs
- Average AUM:The total value of all investors’ money in that fund
Calculation of Expense Ratio
Now that you have understood what is mutual fund expense ratio let us assume a hypothetical equity mutual fund scheme with AUM (assets under management) of Rs 700 Cr, and the expenses it bears for the above-mentioned costs sum up to Rs 14 Cr.
Hence, the expense ratio formula will be Rs 14 Cr/Rs 700 Cr= 2%
This implies that in a year, each investor will have to pay 2% as the expense ratio to the AMC, which will be deducted each day till the time you are invested in the scheme.
Components of Expense Ratio
There can be multiple types of expenses associated with a mutual fund expense ratio, like-
- Fund Manager’s fee: Every mutual fund comes with an investment objective and it is the fund manager’s decisions that ensure that these objectives are met. Such actively managed mutual funds’ expense ratio includes the compensation to the fund manager as a part of the expense ratio. For passively managed funds, this component of the mutual fund expense ratio is far lower than actively managed, because the fund manager need not actively manage the fund’s portfolio in the former.
- Legal/Audit fee: Mutual funds are governed by the Securities and Exchange Board of India, and hence, to comply with all the regulations and laws, they need constant legal intervention and audits of their processes, schemes, etc. Any costs pertaining to audits, registration, transfers, legal checks, etc., are also a part of the expense ratio.
- Marketing/Distribution fee: – The costs pertaining to the mutual fund’s marketing, creating awareness, and then getting it distributed through mutual fund distributors are a part of the expense ratio. The cost component for intermediaries is lesser for direct funds and higher for regular funds because when you invest in a regular fund, there are costs for brokers like the distributors. This fee is also known as the brokerage fee. Hence, investment in direct funds via ET Money will prove to be cheaper than regular funds. The former part about marketing and pamphlet distribution also comes under the 12B-1 fee.
Example of Expense Ratio
Let us understand the expense ratio meaning with an expense ratio example, assuming your mutual fund scheme’s expense ratio is 1.25%. If your investment in this fund is Rs 1,00,000, and assuming your investment value grows to Rs 1,00,500 and 1,00,125 on two subsequent days, this is how much expense ratio you pay on each day-
| Date | Value of investment on the day | Expense Ratio |
|---|---|---|
| 1st Jan 2021 | Rs 1,00,500 | (1.25%/365)*1,00,500= Rs 3.44 |
| 3rd Mar 2021 | Rs 1,00,125 | (1.25%/365)*1,00,125= Rs 3.42 |
You pay Rs 3.44 on 1st Jan, Rs 3.42 on 3rd Mar, and so on. Each day, a portion of your corpus is being paid to the fund house as the expense ratio, thereby reducing the returns. Irrespective of whether the returns are positive or negative, this expense ratio must be paid until you stay invested.
Broadly speaking, the costs mentioned above comprise the mutual fund expense ratio.
What are the Expense Ratio Limits?
The Securities and Exchange Board of India has levied some limits on the various types of mutual funds when it comes to the expense ratio-
For actively managed mutual funds:
| Assets Under Management (AUM) in Crores | Total Expense Ratio (TER) limit for equity schemes | Total Expense Ratio (TER) limit for other than equity schemes |
|---|---|---|
| Rs 0-500 | 2.25% | 2.00% |
| Rs 501-750 | 2.00% | 1.75% |
| Rs 751-2000 | 1.75% | 1.5% |
| Rs 2001-5000 | 1.6% | 1.35% |
| Rs 5001- 10,000 | 1.5% | 1.25% |
| Rs 10,001- 50,000 | 0.05% total expense ratio reduces with every increase of Rs 5000 Cr of daily net assets | 0.05% total expense ratio reduces with every increase of Rs 5000 Cr of daily net assets |
| Remaining assets | 1.5% | 0.80% |
For passively managed and closed-ended mutual funds:
| Scheme | Maximum Total Expense Ratio (TER) |
|---|---|
| Close-ended equity-oriented or interval schemes | 1.25% |
| Other than close-ended equity-oriented or interval schemes | 1.00% |
| Exchange-Traded Funds (ETFs)/ Index Funds | 1.00 |
| Fund of funds (FoFs) that invest in actively managed equity schemes | 2.25% |
| Fund of funds (FoFs) that invest in actively managed other than equity schemes | 2.00% |
| Fund of funds (FoFs) that invest in liquid funds, index funds, or ETFs | 1.00% |
Importance of Mutual Fund Expense Ratio
Now that you have understood the expense ratio let us understand its importance in your mutual fund journey-
- It is evident from the examples above that the higher the expense ratio, the lower your returns will be. At the same time, a higher expense ratio does not imply it’s a better mutual fund. A fund with a lower expense ratio can be equally or more capable of producing better returns.
- The expense ratio of a regular fund is higher than a direct fund. This is because while you invest in a direct fund through the AMC or platforms like ET Money, regular mutual funds are distributed through mutual fund distributors. Hence, the commission to the distributor also becomes a part of the expense ratio. Over some time, this commission has the potential of significantly lowering your returns.
- If you are looking at two similar mutual funds, the expense ratio can be one of the factors to decide which fund to invest in. For example, if you are looking at two large-cap equity funds A and B, with similar holdings and investment objectives and expense ratios of 1.5% and 2%, respectively, your choice will clearly be fund A.
- The expense ratio impacts debt funds more because of the relatively lower returns. A return of 7% with an expense ratio of 2% will be reduced to 5% and won’t be good enough to beat inflation.
Impact of Expense Ratio on Mutual Fund Returns
A fund’s expense ratio significantly determines the overall return of your mutual fund investment as it directly affects a fund’s NAV (Net Asset Value). If a fund has a lower expense ratio, its NAV will be higher.
Implication of Expense Ratio
The expense ratio in a mutual fund is indicated as a percentage of the total AUM (Asset under management), representing the fund’s operating expenses. These expenses are deducted from the AUM to declare the fund’s NAV (Net asset value) daily, thereby reducing the overall return from the mutual fund.
Many of us believe that funds having a higher expense ratio will give us higher profits in future, as they are managed by the top professional and are passively managed. However, funds with lower expense ratios but managed by the best fund managers, then in this case they can also deliver higher returns.
A higher expense ratio can erode your overall return from the mutual fund but can not be a prime indicator of its performance. Other factors, such as XIRR, past performance, fund managers, etc., should also be considered before selecting the fund.
Expense Ratio Limit by SEBI
As mutual funds are regulated by the SEBI (Securities and Exchange Board of India), they have prescribed the maximum percentage of expense ratio that can be charged from the investors. These rates vary based on the type of funds (Equity or non-equity, Fund of funds (FoFs), ETFs, etc.) and the AUM of the fund.
For example, in the case of equity-oriented funds, if the AUM of the fund is upto Rs 500 crore, then the maximum expense ratio can be 2.25%, and if the AUM is between Rs 501 crore and Rs 750, then the maximum expense ratio can be 2%.
While for debt funds, for AUM upto Rs 500 crore, the maximum expense ratio can be charged upto 2%, and if it is between Rs 501 crore to Rs 750 crore, then the maximum expense ratio can be 1.75%.
Things to Remember about Expense Ratio
Now that you are well versed with what is the expense ratio and how it impacts your returns, let us note the things to remember-
- The expense ratio is the cost you are paying to the AMC for the management of the fund.
- A lower expense ratio is always favorable, but align your investment objectives with the mutual fund. Don’t blindly go with the ones with a lower expense ratio.
- The expense ratio of regular plans is higher than direct plans, and also that of actively managed funds is higher than passively managed.
- It has a higher impact on debt funds because the returns from debt funds are relatively lower. Deducting the expense ratio from the returns can make them ill-equipped to beat inflation.
- You can use the expense ratio to compare mutual funds.
- It is deducted from your investment amount daily; you don’t pay it separately to the AMC.
- A fund with a higher AUM is likely to have a lower expense ratio because the management costs are getting distributed amongst more investors vis-a-vis a fund with a lower AUM.
Frequently Asked Questions (FAQs)
What is a good expense ratio for a mutual fund?
The lesser, the better, we’d say. There is no number to a ‘good’ expense ratio; it is always looked at in comparison to another. It is best kept low because it is your hard-earned money, after all, and every penny counts. But you may also want to look at the fund and if it meets your investment objectives. If the returns gathered are worth the cost, then that makes sense.
Do all mutual funds have expense ratios?
Yes, every mutual fund comes with an expense ratio. The % can be less or more depending on whether the fund is actively or passively managed or a regular or direct plan. But it is definitely always there.
Is the expense ratio charged every year?
It is charged every day till you stay invested. The value of the expense ratio is prorated and charged to your investment amount each day. The everyday calculation ensures that you pay the fee only for the time you are invested, and not for the whole year in one go.
Why Is Expense Ratio Important?
The expense ratio for a mutual fund affects the returns you garner from it. It is a fee that you are paying to the fund house for the management of your investment. It is essential to lower this amount paid because it is deducted from your investment value each day. Hence, as your corpus grows, the amount you pay as the fee also grows considerably. The smarter way to invest is to choose direct plans in order to minimize the expense ratio. The expense ratio can also be used to compare two funds and choose which one to invest in if they belong to the same category.
Do mutual fund returns include expense ratio?
The mutual fund NAV is calculated after deducting the expense ratio every day; hence, the returns are net of the expenses. In other words, the returns expressed are what the investors gathered after deducting the expense ratio.
Does NAV include the expense ratio?
The NAV is calculated after deducting the expense ratio. Hence, it is net of the cost. The expense ratio is deducted from the value of the mutual fund scheme’s assets that day and divided by the number of outstanding units to derive at that particular day’s NAV. Hence, the higher the expense ratio, the lower the NAV will be.
Does NAV matter in mutual funds?
Yes, very much. It is the cost at which you buy every mutual fund unit. And the fluctuation in NAV can also help you identify to gauge the past performance of the fund. Beyond this, NAV is not relevant in comparing two mutual funds or even deciding whether or not to invest in a particular mutual fund. The value of NAV does not make any fund good or bad.
