What is Expense Ratio in Mutual Funds & How they Work

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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 advertise 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 the 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. 

Components of Expense Ratio

There are various types of charges in the Expense ratio of mutual funds. Some of these charges are:

Management fees: This is the fee which is given to fund managers and other analysts who are involved in managing the fund. The management fee is calculated on the total AUM at the end of a period on which the fees are paid. Fund managers give their time and energy to make a good portfolio for the fund and determine the investment opportunities.

Maintenance/Administrative expense: It is the expense which is incurred for conducting smooth operations and other administrative operations. These expenses are incurred on keeping records, customer support, etc.

12-1b Distribution fees: This is the fee which is charged from the investors to promote and advertise the fund. The expenses which are incurred for the advertisement and promotional purpose comes under the distribution fees.

Commission and Brokerage fees: This is a fee that is paid to brokers hired by the AMC. The broker is one who processes the transactions at the time of the purchase and sale of the mutual funds and is paid commissions in return.

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 a 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.

Impact of expense ratio on returns

The expense ratio impacts the return of a mutual fund as the expenses are paid out or deducted from the return of the fund.

Let us understand this with an example

Mutual Fund A has an expense ratio of 1.00% and Mutual fund B has an expense ratio of 0.50%.

Suppose you have invested Rs.5000 each on 1st January 2020 in both the funds. And both these funds have generated a return of 20% in a year. Now, on 31st December 2020, the value of an investment will be Rs.6,000 before the expense ratio.

Expense ratio of mutual fund A: 1.00% * Rs.6,000 = Rs.60. So the current value will be Rs.5,940 and the 1-year return from the fund will be 18.8%.

Expense ratio of mutual fund B: 0.50% * Rs.6,000 = Rs.30. So the current value will be Rs.5,970 and the 1-year return from the fund will be 19.4%.

From the above example, we can easily understand how the expense ratio impacts the return as both the funds generated a return of 20%, but after deducting the expense ratio, the net returns of these funds have a difference of 0.60%.

Frequently asked questions

Q. What is an expense ratio?

A. The expenses which are incurred for running and managing the mutual fund are the expense ratio of a mutual fund. The fund house bears many expenses like the cost for daily operation, fees for fund managers, administrative expenses, etc. All these expenses are covered from the fund’s AUM and are called the expense ratio.

Q. What is the impact of an expense ratio?

A. As the expense ratio is a part that is deducted from the scheme’s total AUM, hence it impacts the return of the fund. A higher expense ratio can lower the return of the fund and vice versa.

Q. What are the components of the expense ratio?

A. Some of the major components of the expense ratio are:

  • Managements fees
  • Maintenance expenses
  • 12-1b Distribution fees
  • Commissions & Brokerage

Q. How is the expense ratio calculated?

A. The expense ratio is calculated on the fund’s total AUM at the time expenses are paid.

Suppose, funds pay the expenses at the end of the month, so the expenses will be calculated on the fund’s AUM at the end of the month.

More Information:

Bharat Bond ETF
Shariah Compliant Mutual Funds
Become a Mutual Fund Advisor 

NISM Full Form in Mutual Fund
 

Last Updated: 8-Jun-2022

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