There are no free lunches and if a mutual fund company is managing your money to make returns for you, that is not free either. An AMC charges you an annual fee called Expense Ratio for the same. Let us understand this aspect of mutual fund investment in detail through the following topics.

  1. What is an Expense Ratio?
  2. What are the Components of Expense Ratio?
  3. How does Expense Ratio impact Fund Returns?
  4. Expense Ratio Limit by SEBI
  5. Illustration showing calculation of TER
  6. Comparative analysis of Expense Ratios
  7. Conclusion

 

1. 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). The asset manager, with the help of a team of analysts and other experts, allocate, manage (including the auditor & advisor fees) and advertise the fund to maximize returns and manage risks.

If the funds’ assets are small, the expense ratio can be quite 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 large, the expense percentage should ideally come down. On 18 September 2018, SEBI brought about major modifications by reducing TER of the mutual funds and changing the method of providing commission to the distributors. Read more about it here ”

2. What are the Components of Expense Ratio?

Expense Ratio includes numerous charges for running the mutual fund scheme in a smooth manner. 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. Hence, it will have 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 requires 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 a compensation for these managers’ expertise. On an average, this annual fee is 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. They can vary greatly and are expressed as a percentage of fund assets.

c. 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. 
Expense Ratio

3. 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. 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 TER 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.

4. Expense Ratio Implications

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. It becomes critical for schemes with comparatively lower 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 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 making a switch.

 

5. Expense Ratio Limit By SEBI

All expenses of an AMC must 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 limit for debt fund is 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). These cities also enjoy an additional 20 basis points as exit load charges.

6. Illustration showing calculation of Total Expense Ratio

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 1000 to manage your money. It can be said that if a fund earns 10% and has a 2% TER, 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% to 3.5% for Tax saving funds in India.

 

Example :

1. If the fund handles Rs 10 Lakh in assets and collects 15 Thousand 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 = 1 Lakh
Other Expenses = 50 Thousand

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

 

7. Comparative analysis of Expense Ratios

Expense ratio can be an important criterion in the selection of mutual funds because it impacts the overall returns a unit holder can earn. Before finalizing on a mutual fund scheme, compare and analyze the funds available based on the cost of investing.

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, it is not the only criteria while selecting mutual fund scheme. A scheme with a consistently decent track record may tell you differently about the TER. Sometimes, higher expense ratio can overshadow the decent returns.  

8. Conclusion

Although high expense ratio impacts the fund returns, it is not set in stone. 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.

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