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Expense Ratio in Mutual Funds – Meaning, Formula, Types & Importance

The expense ratio is the cost of running and managing a mutual fund, to deliver said mutual fund returns by the asset management company.
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Professional management for a small fee

You should choose a mutual fund scheme that suits your risk profile and is aligned with your financial goals. After you finalize the mutual fund scheme, when you invest, your money is managed by professional fund managers. They have the best educational qualifications along with years of work experience in managing people’s money. These highly valuable services from the professional fund manager and other services from the mutual fund house come at a cost to you. Learn about what is expense ratios in mutual funds in this article.

Expense ratio and its components

SEBI permits the incurring of certain operating expenses for managing a mutual fund scheme. Some of these expenses include:

  1. Marketing and selling expenses including agents’ commission
  2. Brokerage and transaction cost
  3. Registrar services
  4. Fees and expenses of trustees
  5. Audit fees
  6. Custodian fees
  7. Costs of statutory advertisements etc.

The above is not an exhaustive list. Also, SEBI may permit the incurring or charging of other expenses from time to time. SEBI allows the incurring of these expenses as a percentage of the fund’s daily net assets. This percentage is known as the expense ratio. In simple terms, the expense ratio is the cost of running and managing a mutual fund scheme.

How much can be charged as an expense ratio?

SEBI has defined the maximum total expense ratio (TER) that can be charged to different types of mutual fund schemes. In the case of actively managed equity schemes, the maximum TER that can be charged is 2.25% of the daily net assets. Similarly, SEBI has defined the maximum TER for debt funds, Exchange Traded Funds (ETFs), index funds, etc. The TER is applied slab-wise depending on the Assets Under Management (AUM). The general rule is the higher the AUM, the lower the TER that can be charged. The TER is reviewed by SEBI from time to time and revised if required.

The expense ratio for different types of schemes

The expense ratio differs for different types of schemes depending on the way the scheme is managed or the involvement of intermediaries or other factors.

  1. Active Funds Vs Passive Funds: In an active fund, the fund manager chooses which stocks to invest in and in what proportion. This involves a lot of time and effort for research. Whereas, a passive fund mirrors the performance of an underlying index. The scheme money is invested in the constituents of the index in the order of their weightage in the index. Hence, the expense ratio in an active fund is higher than a passive fund, other things being constant. Passive funds have a substantially lower TER as there is hardly any active role played by the fund manager.
  2. Regular plans Vs Direct plans: Regular plans involve the role of a mutual fund distributor for various services such as scheme selection, customer on-boarding, regular review, redemption, etc. The AMC pays a commission to the mutual fund distributor for providing these services to the mutual fund scheme customers. Whereas, direct plans are bought directly from the fund house without the involvement of a mutual fund distributor. Hence, the TER of a direct plan is much lower than that of a regular plan.

How does the TER impact your returns?

As an investor, the TER directly impacts your mutual fund returns. The higher the TER, the lower your returns, other things being constant. The difference in the TER for a direct plan and a regular plan can range from 0.5% to 1.0%.

Let us assume that there is a difference of 1% in the TER of a regular plan and direct plan of the scheme. Let us assume that the regular plan of the scheme has generated 11% annualised returns and the direct plan has generated 12% annualised returns due to the difference in TER. Let us see how will this 1% difference in return impact your net returns over a period of time if you invest Rs. 1,20,000 per annum (Rs. 10,000 per month) through a SIP.

Investment time horizon11% annualised returns12% annualised returnsDifference in returns
5 years₹ 7,47,336₹ 7,62,342₹ 15,006
10 years₹ 20,06,641₹ 21,05,848₹ 99,207
15 years₹ 41,28,643₹ 44,73,566₹ 3,44,923
20 years₹ 77,04,340₹ 86,46,293₹ 9,41,953
25 years₹ 1,37,29,597₹ 1,60,00,064₹ 22,70,467

As can be seen from the above table, a 1% difference in annualised returns due to a difference in total expense ratio (TER) can impact your returns significantly over long periods of investments. However, you should not undermine the role of a financial advisory firm if you are not well versed with mutual fund investments. By avoiding a financial advisory firm if you end up investing in the wrong mutual fund scheme, the notional loss can be much higher than the savings from avoiding financial advisory services.

To invest in direct plans of mutual fund schemes and invest for your life goals, download the Glide Invest app now and start

FAQs

Q1: What can be understood by Expense Ratio? 

A1: The annual cost charged to an investor for the management of his or her money is known as the expense ratio. 

Q2: How are mutual fund expense ratios calculated?

A2: The whole amount of fund fees—both management fees and operating expenses—is divided by the total value of the fund's assets to determine the expense ratio. Consider two mutual funds that both generate a 5% average yearly investment return, but one charges 1% and the other charges 2% in fees. Most investors may not notice the difference of a single percentage point, but it is because the charge is calculated based on assets under management rather than the profit earned.

Q3: What effect does the expense ratio have on fund returns?

A3: Expense ratios show how much the fund costs in percentage terms to manage your investment portfolio on an annual basis. If you invest Rs.20,000 in a fund with a 2% expense ratio, you will have to pay the fund house Rs.400 in order for them to handle your money.

Q4: Is there some kind of a limit set to the Expense Ratio in Mutual Funds by any regulatory body? 

A4: All of an AMC's expenses must be controlled within the parameters set forth in Regulation 52 of the SEBI Mutual Fund Regulations. According to these rules, the total expense ratio (TER) for the first Rs.100 crore of average weekly total net assets is 2.5 per cent, 2.25 per cent for the following Rs.300 crore, 2 per cent for the next Rs.300 crore, and 1.75 per cent for the remaining AUM. The debt fund ceiling is 2.25 per cent. Furthermore, the Securities and Exchange Board of India permits all mutual funds to charge an additional 30 basis points as an incentive to expand into smaller areas (B15 Cities). Exit load charges of 20 basis points are also available to these cities.

Q5: In mutual funds, what can be considered a good expense ratio?

A5: For an actively managed portfolio, a decent expense ratio from the investor's perspective is roughly 0.5 per cent to 0.75 per cent. A high expense ratio is one that exceeds 1.5 per cent. In contrast to exchange-traded funds (ETFs), mutual funds generally have higher expense ratios.

Q6: Is there a provision that the expense ratio on Mutual funds is changed over time?

A6: The Total Expense Ratio is a fee levied to Mutual Fund investors to cover these expenditures (TER). The TER of a mutual fund might fluctuate over time. However, in most circumstances, the change in total expense ratio is quite small, such as 0.01 per cent or less, and such small changes might happen fairly frequently.

Q7: Will I be charged an expense ratio every month?

A7: No, An expense ratio is a fee charged to investors in mutual funds and exchange-traded funds(ETFs) on an annual basis.

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