1. What is an Expense Ratio?
Annual Fund Operating Expenses is better known as the expense ratio. It is the percentage of assets paid to administer, manage (including the auditor & advisor fees) and advertise or to meet the other expenses of the mutual fund. If the funds’ assets are small, the expense ratio can be quite high so that the fund can meet its expenses from a restricted or a smaller asset base. If the net assets of the fund are large, the expense percentage should ideally diminish as expenses are spread across a wider asset base.
2. What are the Components of Expense Ratio?
Expense Ratio is composed of numerous charges that are required to run the administration of the mutual fund scheme in a smooth manner. Such cost is recovered from the mutual fund investors on a day-to-day basis but it is disclosed only once in every six months. It has a substantial impact on your take-home returns.
There are 3 major types of expenses as a part of the Expense Ratio :
a. Management Fees
Mutual funds are a sophisticated product which requires formulation of investment strategies before actually investing money in the underlying assets. Fund houses appoint fund managers for managing mutual fund schemes. Fund managers need to possess a high level of educational, relevant fund management experience and professional credentials. The management fee or investment advisory fee is used to compensate the managers of the portfolio. On average this fee is annually about 0.50% – 1.0% of the funds’ assets.
b. Administrative Costs
The administrative costs are the expenses of running the fund. This would include record keeping, customer support, and service, information emails, communications. These costs can vary greatly and are expressed as a percentage of fund assets.
c. 12-1b Distribution Fees
The 12-1b distribution fee is collected by most of the mutual funds for advertising and promoting the fund. Most of the mutual funds charge their shareholders to market and promote the fund to the investors. These three fees combined are equal to the percentage of assets deducted from the fund also known as the mutual fund expense ratio.
3. How does Expense Ratio impact Fund Returns?
Expense ratio indicates how much the fund charges in terms of percentage annually to manage your investment portfolio. If you invest Rs 20,000 in a fund which has an expense ratio of 2%, then it means that you need to pay Rs 400 to the fund in order to manage your money. Simply put, if a fund earns returns equal to 15% and has an expense ratio of 2%, then you would earn a return equal to 13%. The Net Asset Value (NAV) of a fund is reported after deducting all fees and expenses. Hence, it becomes important to know that how much are you paying to the fund.
Expense ratio indicates the percentage of sales to the total of individual expense or a group of expenses. A lower ratio means more profitability and a higher ratio means less profitability. Expense ratio becomes critical in case of debt funds especially in a universe of low yields. Apart from that, you may use expense ratio to differentiate between actively managed and passively managed funds. In case of actively managed equity funds, the alpha generated by the fund manager is a crucial justification of the expense ratio charged by the fund. If you find a wide divergence between the returns of your fund and index funds, then you may think of making a switch.
Although high expense ratio impacts the fund returns, it is not necessary that high expense ratio will always give low returns. If the funds are managed in an aggressive manner then high returns can be an outcome of high expense ratio due to the choice of investment and good stocks in the asset.
4. Illustration showing calculation of Total Expense Ratio
All expenses incurred by a Mutual Fund AMC will have to be managed within the limits specified under Regulation 52 of SEBI Mutual Fund Regulations. As per these regulations, the total expense ratio (TER) allowed is 2.5 % for the first ₹100 crore of average weekly total net assets, 2.25 % for the next ₹300 crore, 2 % for the next ₹300 crore and 1.75 % for the rest of the AUM. The debt funds are allowed an expense ratio of 2.25%. On top of this, Securities and Exchange Board of India allows all the mutual funds to charge 30 basis points more as an incentive to penetrate in smaller towns (B15 Cities) and an additional 20 basis points as exit load charges for these cities.
For example, if you invest Rs 50,000 in a fund with an expense ratio of 2 percent, then you are paying the fund Rs 150 to manage your money. It can be said that if a fund earns 10 % and has a 2 % expense ratio, it would mean an 8 % return for an investor. The Mutual Fund’s NAVs are reported after netting off the fees and expenses and hence, it is necessary to know how much the fund is deducting or charging as expenses.
Mutual fund expense ratios range from 0.1 % – 3.5% for Tax saving funds in India.
5. Comparative analysis of Expense Ratios
Expense ratio can be an important criterion in the selection of mutual funds because it impacts the overall returns earned by the unit holder. Before finalizing on a mutual fund scheme, it is necessary to draw a comprehensive comparative analysis of the funds available based on the expense ratio.
|Name of Mutual Fund||Type of Mutual Fund||Expense Ratio|
|Axis Long-term Equity||ELSS||1.97%|
|Edelweiss Tax Advantage||ELSS||2.68%|
|SBI Small and Mid-cap||Small and Mid Cap||2.28%|
|Reliance Small Cap||Small Cap||2%|
|HDFC Growth Direct||Large Cap||1.61%|
Though the expense ratio is important, still it is not the only criteria while selecting mutual fund scheme. A scheme with a consistently decent track record, decent returns but a higher expense ratio may be better or at par than the one with a lower expense ratio which can give a lower return due to the suboptimal choice of investments.
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