What is Expense Ratio in Mutual Funds & How they Work

What is Expense Ratio

As you would know the money invested in a mutual fund is pooled together and then allocated to various assets or securities based on the investment objectives of the particular scheme. As one can imagine, this would entail various costs which include, but are not limited to the following:

  • Fund Manager Expenses – An expert in the given asset class is employed by the Asset Management Company (AMC), who along with his team of analysts and researchers, help find the best securities to invest the money of the mutual fund in.
  • Advertisement and Marketing Expenses – an AMC needs to advertisie and market their products in order to get more assets under management for each fund. A fund with lesser assets will have higher expenses as the fixed costs would be the same.
  • Distribution Expenses – Mutual funds offer commissions to distributors who also double up as advisors to the investor. These distributors are not permitted to charge a fee to the investor and hence must rely on the commissions offered by the AMC.
  • Administrative Expenses – There are various other expenses such as auditors’ fees, advisors’ fees and maintenance expenses.

The costs to cover the above expenses are recovered from the AUM with the fund and is denoted as a percentage of the total assets. This proportion is known as the expense ratio of the fund.

How does Expense Ratio work?

The percentage indicates the amount that the fund charges annually to manage the investment portfolio. Let’s say you invest Rs. 50000 in a fund with an expense ratio of 1.50%. Every year the fund house would deduct an amount of Rs. 750 (1.50% of Rs. 50,000) as expenses. To know your net returns from the fund you need to simply subtract the expense ratio from the gross returns. This makes the expense ratio a very important factor to consider while investing in a fund. 

Is there a Limitation on the Expense Ratio?

Under regulation 52, SEBI has specified limits within which the mutual fund AMC will have to manage all the expenses incurred. This is as below:

Fund Style ->EquityDebt
AUM (avg net weekly)  
First Rs. 100 Crore2.50%2.25%
Rs. 100 Crore – Rs. 400 Crore2.25%2.00%
Rs. 400 Crore – Rs. 700 Crore2.00%1.75%
Rs. 700 crore & above1.75%1.50%

Source: AMFI

In addition to the above, mutual fund companies have been allowed to charge up to 30 bps or 0.30% more, if at least 30% of their net inflows come from locations beyond the top 15 cities. This is done in order to increase the penetration to tier-2 and tier-3 cities.

Does higher Expense Ratio imply a more expensive product?

Not necessarily. One must bear in mind that the idea of the expense ratio is to better manage the portfolio. The investors aim is to get the returns commensurate with the risk he is taking in the portfolio. If a given fund manager can better manage a portfolio, a prudent investor would rather pay a slightly higher expense ratio than to go with a risky portfolio. A superior portfolio and performance of the fund are more critical than the expense ratio.

In conclusion, the expense ratio of a fund is an important factor while selecting the right fund. However, it should not be the primary factor. While selecting a fund, an investor must find funds which meet his risk-return objectives and then go on to factors such as expense ratio to select the best.

More Information:

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Last Updated: 26-Dec-2020


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