What Is Expense Ratio In Mutual Fund – Meaning, Calculation and Importance

Mutual Funds is one such financial instrument which helps in long term investment. In short, you will have some additional amounts apart from your regular savings in your account after your retirement. Well, nothing comes free of cost!

Have you ever realized that whatever investments you are doing in Mutual Fund a percentage of it is getting deducted as a fee? Yes, This fee is known as Expense Ratio. Here we will make you understand what is Expense Ratio, Why it is important, Components of Mutual Fund Expense Ratio, How Does it impact fund return, Sebi Limits for Mutual Fund Expense Ratio and Expense Ratio Implications

So Let us begin with 

What is an Expense Ratio?

The Mutual Fund Expense Ratio is the fee charged by mutual fund firms or exchange traded fund (ETF). This fee includes administration, portfolio management, marketing and more. It is usually percentage based. Value of the expense ratio depends on the size of the mutual fund. Expense Ratios have inverse relationship with the size of the respective mutual fund.

How To Calculate Expense Ratio

Expense Ratio = Total Expenses/Total Assets of the Funds

Where higher the asset lower will be the ratio and vice versa.

Let us understand this concept with an example

Suppose there is Mutual Fund Company has Asset under Management worth Rs 4 Crores. In order to Manage the fund, Fund House charges fees for administration, management and distribution amounted to Rs 4,00,000/-

The total expense ratio for this fund would be calculated as below:

Expense ratio = 5 lakhs/5 crores = 1%

 1% is the amount of the total assets that need to be paid out in order to manage the fund. 

Components of Mutual Fund Expense Ratio

• Administrative Costs

The administrative Cost are the expenses incurred for running the fund. This includes keeping the records, customer support and service, information emails, and other way of communication.

• Brokerage Fees

There are basically two plans in Mutual Funds- Direct or Regular.  In case of Direct Mutual Funds do all transactions by themselves. Whereas in Regular Plan Asset Management Companies hire brokers for all transactions to be processed concerning the purchase and sale of the shares of the portfolio asset. There are Brokerage fees involved which is a part of  Mutual Fund expense ratio.

• Audit Fee

Mutual funds are governed by the Securities and Exchange Board of India. So there are frequent audits which helps in complying the rules and Regulations laid down by SEBI. Any cost associated with audits, registration, and transfers etc. are part of expense Ratio.

• Distribution Fee

The cost which are incurred for marketing, creating awareness and getting the mutual fund distributed are part of expense ratio. The cost component for intermediaries is lesser for direct funds and higher for regular funds. As we said in earlier point there is no broker involved in direct funds whereas in Regular funds there are Brokers and Distributors involved. So this shoots up the cost.

• 12B-1 Fee

12B-1 fee are the fees which a fund manager collects from you and the other shareholders for advertisements to get more investors. The larger the number of shares a company has under management, the less it costs them to advertise because the cost is divided among everyone. Generally 12B-1 fees covers two kinds of expenses:

1. Distribution Expenses
2. Service Expenses

• Entry Load

Mutual Fund Companies earlier used to charge a sum from investors as they enter the scheme. This fee is called load in general. Entry Load is cost paid when joining as an investor. But after August 2009, SEBI discontinued charging the entry load for mutual fund investments.

• Exit Load

When Mutual Fund Companies impose the price on investors at the time of exit or redemption of the mutual fund units held it is called Loan Exit Load. If an investor leaves the fund within earlier before certain period of time he will have to pay exit charge. The number of withdrawals from the mutual fund scheme can also be limited by this charge. Hence the fund managers will be in a better position of managing the funds and take investment decisions without the disruption of frequent redemptions.

Mutual Fund Expense Ratio Limit By SEBI

SEBI has set certain limit on Expense Ratio charged by Mutual Fund Companies in order to protect the interest of the investors. Effective from April 1, 2020 the TER limit is as follows :-

In addition, mutual funds have been allowed to charge up to 30 bps more, if the new inflows from retail investors from beyond top 30 cities (B30) cities are at least

(a) 30% of gross new inflows in the scheme or

(b) 15% of the average assets under management (year to date) of the scheme, whichever is higher.

This is essentially to encourage inflows into mutual funds from tier – 2 and tier – 3 cities.

Thus, TER is an important parameter while selecting a mutual fund scheme.

How Does Expense Ratio Impact Funds Returns

• Mutual Fund Expense Ratios are the expenses which are deducted from the total revenue generated, before disbursing it to the investors.
• Higher expense Ratio indicates revenue will be that much less, thereby giving the investors less returns.
• In a way expense Ratio can become a burden for the investor and so one should analyses the same carefully.
• When Expense Ratio are higher it is assumed that management is performing better and is generating higher profits. But this is a misconception. Mutual funds with low expense ratio also generates higher returns with the help of professionally trained managers.
• There are two things that must be considered: the impact of high fees and the impact of compounding. While Investing we are often told about the power of compounding to amplify the investment returns over the years. However, compounding also applies to fees because they are charged as a percentage of your position in that fund.

Importance of Mutual Fund Expense Ratio

• 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.
• 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.
• 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.

Things to remember about Mutual Fund Expense Ratio

• Expense Ratio is the cost paid to the AMC for the management of the fund.
• Lower Expense Ratio is always favorable but aligning of investment is important. Do Not trust the lower expense ratio blindly.
• Expense Ratio has impact on the debt funds because debt funds returns are comparatively lower and deducting the expenses from the returns will be an additional burden.
• It is deducted from your investment amount daily; you don’t pay it separately to the AMC.,