What is Expense Ratio in Mutual Funds?: Components & Formula

When investing in a mutual fund, every investor must know the expense ratio in mutual funds. Many investors rely on their financial advisors for guidance in the stock market and their professional credibility to manage their mutual fund investments. These advisors have in-depth knowledge as well as the expertise to generate returns for their investors. 

Now, managing a person's portfolio is not an easy task. It involves a lot of resources, both human and technical, and if you want to ensure the availability of these resources to investors, funds are needed. As with any business, mutual fund houses will need funds to operate these management operations. SEBI has therefore permitted mutual fund houses to charge investors a certain percentage of operating expenses. This charge is called the expense ratio of mutual funds.

In mutual funds, the expense ratio refers to the fees charged to investors for using the mutual fund house's platform services. These fees are also known as annual fund operating expenses. It is presented in the ratio since it computes the per-unit costs of managing the fund.

A mutual fund expense ratio indicates 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.  As a result, mutual fund houses charge investors a certain percentage for managing their funds. The ratio is dependent on the assets under management. 

What are various components of the expense ratio? 300-400 - numbered bullets

When calculating expense ratios, there is more than one charge to consider. These fees vary by the fund house. Some fund houses may include entry or exit loads in their expense ratio, while others may charge them separately. The charges are levied upon purchase or early sale of the securities. Thus, the mutual fund expense ratio is a summation of several charges. In this section, we will discuss the common components of the expense ratio of mutual funds :

Administrative fees

• The first charge is the cost of running the mutual fund's administrative functions. This is the fee for operating the fund. The rental of the office space, shareholder's services, maintaining transaction records, and any other office expenses includes all expenses necessary to ensure the efficient running of the mutual fund house. The administrative costs also include providing customer service to their investors to resolve any questions or concerns.

Management fees

• As the name implies, it refers to the cost of managing the funds of investors who have hired the assistance of a mutual fund house. Managing an investor's portfolio requires the availability of professional advisors who, after thorough research, determine which stocks to invest in to gain maximum returns. Technical tools may also be used to generate predictions. Therefore, the management fees include recruiting such expert advisors to offer top service to the investors. 

12b-1 fees

• For any business to grow and expand, they need to spend on advertising and promotions. To attract investors, funds need to build their reputation on the market. Hence, promotions are necessary for newly launched funds to establish their asset base in the market.

Brokerage fees

• Brokers are sometimes hired by mutual fund houses to handle all transactions related to purchasing and selling shares. This type of plan is known as a regular plan mutual fund. The expense ratio includes the cost of hiring brokers. Therefore, investors should carefully read the details of each mutual fund before investing. 

Legal fees

• A mutual fund house may also include the costs of hiring lawyers for obtaining licenses, negotiating contracts, processing stock certificates, or handling legal disputes. In that case, they would also be included in the expense ratio. 

How is the expense ratio calculated? 

Now that you understand the expense ratio and its components let’s understand the expense ratio formula. As said before, the expense ratio involves the measurement of the unit cost of a fund. Thus, the expense ratio is the total expenses incurred by the fund house divided by the fund’s average value or the fund or the fund’s total assets. Alternatively, we can say :

Expense ratio formula = Total cost of the fund/Total assets of the fund

Implications of expense ratio

As mentioned earlier, one of the significant factors to consider when selecting a mutual fund is the expense ratio. The expense ratio in a mutual fund directly affects an investor's returns. By calculating the expense ratio, investors can see how much they will receive after reducing all the expenses and determine if the fund is worth investing in. An investor should take into consideration the following points when evaluating the expense ratio:

• When calculating the expense ratio, it means considering all the expenses a mutual fund house incurs. More expenses, however, does not mean the mutual fund will give better services to its investors. There is no evidence that a high expense ratio indicates better portfolio management and higher returns. A mutual fund house with a lower expense ratio may have better resources to produce higher returns.
• Another thing that needs to be taken into account is the plan of the mutual fund. Since a regular plan mutual fund hires brokers, the brokerage fee is included in the expense ratio. However, if the investor chooses a direct plan mutual fund, they can avoid these brokerage fees, manage the fund themselves, and avoid a higher expense ratio. 
• The expense ratio directly measures the fund expenses deducted from the fund revenue before distribution to investors. Alternatively, we might say that higher expense ratios mean higher expenses and, consequently, lower fund returns for investors. Since it affects the investor's returns, it becomes a key factor to review before investing. 

Limit by SEBI on expense ratio 

For expense ratio, mutual fund houses need to abide by limits under section 52 of the SEBI mutual fund regulations :

• For the first Rs100 crore of AUM, the AMC can charge 2.5% as the total expense ratio (TER).
• For the next Rs300 crore of the AUM, the AMC can charge 2.25% as the TER.
• For the next Rs300 crore of the AUM, the AMC can charge 2% as the TER.
• For the balance of the portfolio assets, the AMC can charge 1.75% as TER.
• For debt funds, the expense ratio limit is 2.25%.

What is a good expense ratio in mutual funds?

As a high expense ratio can dramatically reduce the value of the investment, it is essential to understand how much expense ratio is acceptable. 

It is necessary to consider whether a mutual fund is active or passive. Since active mutual funds do more research and involve professional managers, their expense ratios tend to be higher than passive mutual funds. Experts consider an expense ratio of 0.05%-0.15% reasonable for passive funds and up to 1% for international stocks. However, as competition increases, the fund houses drastically reduce their expense ratios to attract more and more investors. 

Outlook

After reading the above article, we hope you have a fair idea of the expense ratio in a mutual fund. Though it may seem like a small amount, it can significantly impact the investment value over time. As a result, investors should consider other factors, such as mutual fund reputation, past performance, and more, when choosing a mutual fund. When in doubt, investors should always consult a financial advisor.