Expense Ratio: Definition, Calculation, Formula and Impact

When it comes to investing in mutual funds, a key factor that is often overlooked by everyone is the expense ratio. This ratio represents all the costs that are associated with the management of a fund and would directly affect your returns as well, thus making it crucial when selecting a mutual fund as even a small variation in an expense ratio can widely impact the growth of your investment.

In this article, we will explain what is expense ratio in mutual fund, how it works, its composition, expense ratio formula, and its impact on your portfolio.

What is Expense Ratio in Mutual Funds?

The expense ratio is the annual fee charged by Mutual Funds to cover their annual operating expenses such as management fees, allocation charges, advertising costs and compliance costs. This fee is expressed as a percentage of the Total Asset Under Management and is deducted from the fund’s return affecting directly on the investor's net gain.

Components of Expense Ratio in Mutual Funds

Expense ratio is comprised of various components each playing a unique role, and understanding these components is essential for an investor to make an informed decision. Below we delve deep into understanding all the components of the expense ratio.

• Management Fees: This fee represents the expense made on the fund manager who has to spend his valuable time and knowledge to achieve the fund’s objective by finding profitable opportunities while also making decisions on behalf of investors.

• Administrative Cost: This cost covers all the operational expenses of the fund incurred by AMC, including costs related to maintaining records, and providing customer support.

• 12B-1 Fee or Marketing Cost: Expenses incurred for marketing and distribution of the mutual fund are included in this cost. This includes payments to financial intermediaries for distribution, commissions on sales, and advertising.

• Compliance Cost: This cost refers to the expenses incurred by the mutual fund house to adhere to regulatory requirements and legal frameworks. These costs are necessary for the fund to comply with all the regulations set by SEBI.

• Brokerage Fees: This cost represent the fees paid to brokers for executing buy and sell transactions within the fund's portfolio. In the case of regular mutual funds, the Asset Management Company (AMC) hires a broker to handle these transactions, incurring brokerage fees. However, in direct mutual funds, the AMC manages these transactions directly, without involving intermediaries like brokers. This helps to avoid brokerage fees, resulting in lower costs for investors.

Expense Ratio Formula

Expense Ratio = Total Fund Expenses / Average AUM * 100

• Total Expenses = The costs incurred by the Asset Management Company, such as Management Fees, Administrative costs, 12B-1 Fees, Compliance and Brokerage Fees.

• Average AUM ( Asset Under Management ) = The total value of all the investors’ money in that fund.

Let’s take an example to get a better understanding. If an Equity MF manages AUM of Rs 1000 crore and incurs Rs  15 crore in expenses, the expense ratio is 1.5%. This means 1.5% of the total fund value is used to cover operational costs.

How is Expense Ratio Charged in Mutual Funds?

The expense ratio in mutual funds is a fee charged as a percentage of the fund's total assets under management (AUM), and it is deducted daily from the fund's Net Asset Value (NAV). Though annually calculated, the expense ratio is divided and deduced in daily terms slightly reducing the NAV before it gets published every day. This expense ratio differs based on the type of the mutual fund. 

Equity-based funds generally have higher expense ratios as they are actively managed, and requires lot of research. While, Debt-based funds, which invest in bonds and other fixed-income securities, have relatively lower expense ratios than Equity-based funds because of their passive investment aproach. Index funds on the other hand, have the lowest expense ratios since they track a specific market index and require minimal research and management effort, resulting in lower costs.

Types of Mutual Funds and Their Expense Ratios

Mutual funds come in various types, and their expense ratios also vary based on management style and the total value of assets under management (AUM).

According to SEBI guidelines, the maximum expense ratio for equity funds is capped at 2.25% for smaller funds, while for debt funds, it is capped at 2%. In both cases, the percentage decreases as the fund size grows. However, for Fund of Funds (FoFs), SEBI has set a lower maximum cap of 1%, irrespective of the fund size. Understanding these differences and regulatory limits can help you choose the right fund for your investment needs.

Impact of Expense Ratio of Mutual Funds on Returns

The expense ratio will have a direct impact on the returns of the mutual fund because they are deducted directly from the fund's AUM, which in turn reduces the net returns for the investor. For instance, if a fund earns a return of 12% in a year and has an expense ratio of 1.5%, the effective return of the investor would be 10.5%. Though this reduction may seem small at first, it can compound significantly over time and potentially erode wealth.

How to Choose Mutual Funds Based on Expense Ratio

• STEP 1: Download the Rupeezy App from the Google Play Store or iPhone App Store

• STEP 2: Open the app and register using your mobile number. Then, complete the verification process by providing the necessary documents.

• STEP 3: After registration open the app, click on the invest section, then select the category you’d like to invest in.

• STEP 4: Now compare the funds in the category

• STEP 5: Select the fund with the higher returns. If two funds delivered similar returns. Select a fund with the lower expense ratio.

• STEP 6: Now invest in the selected fund by clicking on One Time or SIP

Conclusion

In a nutshell, the expense ratio is the most important thing that an investor should consider when investing in mutual funds. The ratio not only gives an idea of how much it costs to run the fund but also has a very significant impact on your investment's overall returns.

The lower the expense ratio, the more of your capital will remain invested, thus allowing a higher chance of growth over the years through compounding. Hence, investors should prefer funds that have competitive expense ratios and assess their performance as well in relation to the investment objectives.

FAQs

Q1. Is the expense ratio charged every year?

Yes, the expense ratio is charged yearly but it spreads out and is deducted daily from the total assets of the fund which is reflected in the daily NAV

Q2. What is a good expense ratio for a mutual fund?

Good expense ratios depend on how the fund is managed. For actively managed funds, a ratio between 0.5% and 0.75% is usually good, while anything over 1.5% is considered high.

Q3. Is the expense ratio charged daily?

Yes. It is charged daily as a fraction of the annual expense ratio. It is deducted from the mutual fund's NAV before publishing the daily NAV.

Q4. Is 1% expense ratio good?

A 1% expense ratio can be considered reasonable or high, depending on the type of mutual fund:

• For Actively Managed Funds: A 1% expense ratio is fair, as these funds involve higher management efforts and research.

• For Index Funds or ETFs: A 1% expense ratio is high since passive funds usually have lower costs.