A Comprehensive Guide to Expense Ratio in Mutual Funds

What Is An Expense Ratio?

The expense ratio is a crucial metric that helps you measure the annual cost of owning mutual funds. In other words, you pay the annual fee to the asset management company (AMC) to manage your mutual fund investment. As an investor, you need not pay the expense ratio separately; it is deducted from your investment value on a daily basis. For example, if you invest Rs 10,000 in a mutual fund with an expense ratio of 2.25%, 0.00616% of your investment is deducted daily as an expense ratio.

The expense ratio is calculated by dividing the total expenses of managing the fund by the average assets under management (AUM).

Expense ratio = Total Expenses/ Average AUM

Total expenses include all the costs involved in managing the mutual fund.

Average AUM is the total value of the investor’s money in that fund

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Components Of Expense Ratio

The total expense ratio of a mutual fund consists of different expenses incurred by the AMC. The mutual fund discloses the bifurcation of these expenses monthly or quarterly. The following are the different components of the expense ratio.

Fund manager’s fees: Mutual funds are managed by fund managers for a small fee. Their decisions are crucial and can make or break the fund. There are two kinds of fund managers: active and passive. The passive fund managers replicate the benchmark index to earn benchmark returns. The active fund managers, on the other hand, do market research to generate market-beating returns. Hence, the fund manager fee for active funds is slightly higher than that of passive funds.
Selling and marketing expenses: To attract investments for a mutual fund, the AMC has to create awareness and advertise. This involves a lot of costs, which the fund recovers through the expense ratio. Moreover, in the case of regular funds, it also has to pay a commission to the distributors for promoting the mutual fund. Hence, the expense ratio for regular funds is slightly higher than that of direct funds.
Legal and audit fee: Mutual funds must ensure they follow all the regulations set by the market regulator. Moreover, to ensure complete transparency in operations, they must follow the compliances and regularly get legal and audit checks. The fee paid for these compliances is the legal and audit fee.
Brokerage fee: Mutual funds buy and sell securities, and every time they do that, they incur certain costs, such as the brokerage fee and securities transaction tax (STT). The brokerage fee will depend on the level of trading activity in the fund. A fund with frequent trading will incur a high brokerage cost, as opposed to a fund with lower trading.

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How Does The Expense Ratio Impact Mutual Fund Returns?

The expense ratio of a mutual fund is deducted from the fund's net asset value (NAV). The NAV is the value of each unit of the fund. An increasing NAV indicates the fund's returns are growing, and a falling NAV indicates the returns are falling. The NAV is published every day after the operating expenses are accounted for. Hence, a high expense ratio will result in a lower NAV as more money is utilized to cover the fund's costs. Therefore, choosing a fund with a lower expense ratio is better.

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Expense Ratio Limits Set Up SEBI

The Securities and Exchange Board of India (SEBI) has set an upper limit for the total expense ratio based on the fund type and AUM. This expense ratio will be effective April 1^st, 2020.

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Debt Mutual Fund Information

Total Expense Ratios for Equity and Debt Funds
Assets Under Management (AUM)	Total Expense Ratio for Equity Funds	Total Expense Ratio for Debt Funds
On the first Rs. 500 crores	2.25%	2.00%
On the next Rs. 250 crores	2.00%	1.75%
On the next Rs. 1,250 crores	1.75%	1.50%
On the next Rs. 3,000 crores	1.60%	1.35%
On the next Rs. 5,000 crores	1.50%	1.25%
On the next Rs. 40,000 crores	Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets or part thereof.
Above Rs. 50,000 crores	1.05%	0.80%

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Factors Influencing Expense Ratio (Direct Vs Regular)

The expense ratio of a mutual fund depends on multiple factors, as stated below:

Fund type: The expense ratio varies based on the type of the fund. For example, an actively managed fund has a higher expense ratio than a passively managed fund.
Fund size: The fund's AUM also influences the expense ratio. A fund with a higher AUM will benefit from economies of scale, as the fixed costs are spread over a larger asset base than a fund with a small AUM.
Management style: A fund manager following a buy and a hold strategy will incur lower expenses than a fund manager who frequently trades in securities. This is because frequent trading will increase the transaction costs.
Expenses: Mutual funds are required to adhere to regulatory compliances and hence will incur compliance costs, which are unavoidable. However, they can control the budget for marketing, advertising, and distribution. A fund with lower marketing expenses will have a lower expense ratio.

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Conclusion

It is crucial to check the expense ratio when investing in mutual funds. A high expense ratio can significantly reduce the fund's returns in the long term. Although a high expense ratio leads to lower returns, it doesn't mean a fund with a lower expense ratio will give superior returns. Apart from the expense ratio, one must consider past performance, portfolio turnover ratio, fund manager efficiency, and other risk measures before choosing a mutual fund to invest in.

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Frequently Asked Questions (FAQS): Expense Ratio In Mutual Funds

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What is a good expense ratio for a mutual fund?

The expense ratio will depend on factors such as the AUM, the fund manager's investment style, and other expenses. There is no standard number for a good expense ratio, but a fund that gives good returns and has a lower expense ratio than its peers is considered good.

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Is the expense ratio charged daily?

The expense ratio is deducted from the NAV daily. If the fund expense ratio is 2%, then 0.00547% is deducted daily from the NAV.

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What is the expense ratio formula?

The expense ratio is calculated by dividing the total expenses of managing the fund by the average assets under management (AUM).

Expense ratio = Total Expenses/ Average AUM

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Is the expense ratio charged on every SIP?

The expense ratio is charged on the total assets of the mutual fund. So, it doesn't matter if you invest in lumpsum or Systematic Investment Plan (SIP); you will be charged the expense ratio every time you invest in the fund.

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Do mutual fund returns include expense ratio?

The movement in the NAV determines the mutual fund returns. The NAV is determined after deducting the expense ratio; hence, the expenses are already accounted for.

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