What Is Expense Ratio And Why Is It Important?

The word, ‘Expense Ratio’, gets thrown around a lot when you read any blog related to mutual funds. It is one of the most important factors one should consider before choosing a mutual fund to invest in.

Here is a detailed guide that will help you understand the ins and outs of expense ratios.

Everything in this world comes at a cost and investing has its costs too. When you invest in a mutual fund scheme, the asset management company (AMC) charges you a fee to manage the funds.

This fee, which is a percentage of the capital invested, is called the total expense ratio (TER).

Diving Deep Into Expense Ratios

The expense ratio is the percentage that denotes the amount of money you are paying to the AMC as a fee to manage your investments.

The expense ratio for a fund is calculated by dividing the total amount of fund fees – both management fees and operating expenses – by the total value of the fund’s assets.

A mutual fund expense ratio shows how much of the fund assets are being consumed by administrative expenses.

If the expense ratio is 1%, it means that 1% of the fund’s assets are used for operating and administrative expenses every year. This ratio depends on the AMC. The expense ratios related to mutual funds are completely regulated by the Securities Exchange Board of India (SEBI).

This information is displayed on the websites of the AMC and the Association of Mutual Funds in India (AMFI).

The expense ratio is calculated by dividing total costs that are borne by the mutual fund with the average assets under management.

In this formula, the total costs borne by the fund are the costs that are incurred by the AMC mentioned above, such as the fund manager’s fee, marketing, and distribution expenses, and legal or audit costs.

Components Of The Expense Ratio

The number of operating expenses incurred while managing investors’ funds differs across different investment companies. Those different charges that are available in consideration of mutual fund expense ratio are:

Management Fee

The management fee is paid by an investor to the portfolio management company as compensation for managing funds on their behalf.

Several funds and portfolio managers regularly spend a considerable amount of time and effort ascertaining the profits in investment opportunities.

A major portion of the management fee can range from 0.5% to 2.0%. Investors prefer portfolio management companies that charge a lower management fee since a higher fee lowers the return on their investments.

12B-1 Expenses

Many mutual funds collect this fee for advertising and promotional purposes. Creating a proper asset base always needs specific information that is required to be distributed among several individuals.

The charges of a separate investment in various mutual funds are managed under the 12B-1 fee. This makes this fee an important component of expense ratios,

Administrative Costs

These are the expenses of running the fund. This includes keeping records, customer support, and service, information emails, and any other way of communication.

Legal Fee

The legal fees are paid to lawyers to process paperwork related to stock certificates, exchange filings, and licenses, as well as compliance with several regulations. Unlike management fees, legal expenses take a small percentage of the expense ratio.

The Impact Of Expense Ratios On Your Returns

The expense ratio directly impacts the returns earned by the fund house. The expense ratio is a recurring expense and can change even after you start investing in a scheme.

If the expense ratio of a mutual fund scheme is 1.5% and you have invested ₹5,000, then you have to pay ₹75 to the fund house for managing the scheme.

If the same mutual fund scheme earns a return of 14%, the effective return you would get will come to 12.5%. In simple terms, the expense ratio is deducted directly from the returns generated by the fund.

Hence, you should be careful when choosing the right mutual fund scheme and choose one with a low expense ratio. A fund with a low expense ratio increases your overall returns and a fund with a high expense ratio lowers your returns.

Limits

Does this mean that fund houses can charge any amount of money as an expense ratio and charge you? Of course not. Capital markets regulator, SEBI has imposed regulations for all AMCs to follow.

According to these regulations, the fund house can charge 2.25% if the AUM is under ₹500 crores and 2% can be charged if the AUM is between ₹500-700 crores.

The charges are capped at 1.75% if the AUM is between ₹750-2000 crores. If the AUM is between ₹2000-5000 crores, the charges can be up to 1.6% and 1.5% if the AUM is between ₹5000-10,000 crores.

Also, there is a 0.5% decrease in expense ratio for every increase of ₹5000 crores AUM if it is between ₹10,000-50,000 crores. The charges cannot be more than 1.05% for AUM more than ₹50,000 crores.

In The End…

The expense ratio is an important criterion when selecting the right mutual fund for you and your goals. When we invest in mutual funds, we do so to get the maximum profit from our investments.

Hence, it is crucial to check the expense ratio before investing because it can reduce the profits that you make to a certain extent.

On top of that, you should read the scheme information document thoroughly to understand all the expenses that you are being charged.

On the other hand, the expense ratio is not the only criterion that is important when selecting a mutual fund scheme.

In some cases, the higher expense ratio can overshadow the good returns offered by the fund. So, if you feel that finding the right mutual fund is a tad bit complicated, then all you need to do is to create an account with Koshex for free.

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You can get all the details of the fund – from the expense ratio to the risk profile, and make an informed decision. Head over to Koshex and create an account for free today!