Expense Ratio : Importance and Analysis

The expense ratio is defined as the annual fee that an investor is charged for the management of his or her funds. Let us understand this cost of mutual fund investment in detail through the following topics.

What is an Expense Ratio?

Annual fund operating expenses, mostly known as the expense ratio, is the percentage of assets payable to the fund manager (i.e. AMC) as the maintenance fee. The asset manager, with the help of a team of analysts and other experts, allocate, manage (including the auditor and advisor fees) and advertise the fund to maximise returns and manage risks. If the funds’ assets are small, then the expense ratio can be high. This is because the fund has to meet its expenses from a restricted or a smaller asset base. Similarly, if the net assets of the fund are significant, then the expense percentage should ideally come down. On 18 September 2018, SEBI brought about significant modifications by reducing TER of the mutual funds and changing the method of providing a commission to the distributors.

AUM (In Rs crore)	TER for equity funds	TER for debt funds
0-500	2.25	2
500-750	2	1.75
750-2000	1.75	1.5
2000-5000	1.6	1.35
5000-10000	1.5	1.25
10000-50000	Starts at 1.5%, and goes down by 0.05% for every rise of Rs 5000 cr in AUM	Starts at 1.25%, and goes down by 0.05% for every rise of Rs 5000 cr in AUM
>50000	1.05	0.80%

What are the Components of Expense Ratio?

The expense ratio includes numerous charges for running the mutual fund plan. They recover this cost from the mutual fund investors on a day-to-day basis. However, they disclose it to the investors once in every six months. Also, this will have a substantial impact on your take-home returns. There are three significant components of expense ratio: There are three major types of expenses as a part of the Expense Ratio. 

Management Fees

Mutual funds require the formulation of investment strategies before actually investing money in the underlying assets. 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 the compensation for the manager’s expertise. On average, this annual fee is about 0.50% to 1% of the funds’ assets.

Administrative Costs

The administrative costs are the expenses of running the fund. This would include keeping records, customer support, and service, information emails, and any other way of communication. This can vary greatly and are expressed as a percentage of fund assets.  

12-1b Distribution Fees

Many mutual funds collect the 12-1b distribution fee for advertising and promotional purposes. Usually, they 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.  

How does Expense Ratio impact Fund Returns?

Expense ratios indicate how much the fund charges in terms of percentage annually to manage your investment portfolio. A small change in expense ratio might cost you a good amount of money. For instance, 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 house to manage your money. Expense ratio is the per unit cost that is needed for managing and running a mutual fund. The higher the fund expense ratio, the lower the returns will be. The TER will vary from one mutual fund to another.

Let’s consider an example of expense ratio.

The expense ratio determines the amount you pay a fund as a percentage of your investment yearly to manage your money. For example, if you invest Rs.2,00,000 in mutual fund with an expense ratio of 1.5% and assume your investment value increases to Rs.2,00,125 and Rs 2,00,500  on two following days, this is how much you need to pay on each day:

Date	Investment Value	Expense Ratio
24 January 2022	Rs.2,00,125	(1.5%/365)*2,00,125 =Rs.8.22
16 February 2022	Rs.2,00,500	(1.5%/365)*2,00,500 =Rs.8.23

Therefore, you need to pay Rs.8.22 on 24 January, Rs.8.23 on 16 February, etc. Irrespective of whether the returns are positive or negative, you need to pay the expense ratio every year till you stay invested. A portion of your corpus will go towards payment of the expense ratio each day. This will reduce your overall returns. 

Expense Ratio Implications

Expense ratio indicates the percentage of sales to the total individual expense or a group of costs. A lower rate means more profitability and a higher rate means lower profits. It becomes critical for schemes with comparatively more moderate 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 compelling justification for the fee they charge. If you find a wide divergence between the returns of your fund and index funds, then you may think of switching.  

Expense Ratio Limit By SEBI

All expenses of an AMC must be managed within 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 Rs.100 crore of average weekly total net assets, 2.25% for the next Rs.300 crore, 2% for the next Rs.300 crore and 1.75% for the rest of the AUM. The limit for debt funds is 2.25%. On top of this, the 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). These cities also enjoy an additional 20 basis points as exit load charges.

Illustration showing calculation of TER

For example, if you invest Rs.50,000 in a fund with an expense ratio of 2%, then you are paying the fund house Rs.1,000 to manage your money. It can be said that if a fund earns 10% and has a 2% TER, then it means 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% to 3.5% for tax saving funds in India.  

Examples : 

1. If the fund handles Rs.10 lakh in assets and collects Rs.15,000 in fees and other charges from the fundholders, then the expense ratio is 1.5%.

2. Total assets of mutual funds X = Rs.1 crore; Administrative expenses = Rs.1 lakh and Other expenses = Rs.50,000

Expense ratio = Total Expenses/Total Assets= Rs.1.5 lakh/1 crore  = 1.5% of your Investment Value

Conclusion

Though the expense ratio is important, it is not the only criteria while selecting a mutual fund scheme. A scheme with a consistently decent track record may tell you differently about the TER. Sometimes, the higher expense ratio can overshadow the decent returns. If tracking markets aren’t your thing and you are finding it too difficult to understand, then invest through ClearTax Save. You can invest in hand-picked funds by our in-house experts in a hassle-free and paperless manner.  

Frequently Asked Questions (FAQs)

What is a good expense ratio for a mutual fund?

There is not a definite number that can qualify as a good expense ratio. However, the lower the expense ratio, the higher returns one can get on the invested capital.

Why is the expense ratio important?

The expense ratio pays for the money that the fund house incurs for hiring a fund manager. The fund manager is responsible for allocating and managing the funds.

What happens when the expense ratio is increased?

When the total expense ratio of the fund is reduced, the returns increases. Conversely, an increase in expense ratio can make investors feel cheated as the amount of return is reduced.

Are expense ratios deducted automatically?

Yes, they are deducted automatically from each investor’s returns.

Can you avoid expense ratios?

Investing in any fund will lead to operating expenses, so if you are a mutual fund investor, you cannot avoid them.

Does NAV include a fund’s expense ratio?

After deduction of expense ratio, the NAV is calculated. The expense ratio is subtracted from the value of the mutual fund’s assets on a particular day and then divided by the outstanding units to determine the NAV of that day.