What Is Expense Ratio In Mutual Fund?

One key metric you should check when investing in a mutual fund is the expense ratio. In this blog, we will cover the expense ratio, the formula to calculate it, and how it works. Then we will examine what is included in the expense ratio and factors affecting it. Finally, we provide a brief analysis on how an increase in expense ratio can affect returns. 

What is Expense Ratio?

It is the annual fees the mutual fund charges to manage your investment. It is calculated as a percentage of the average asset under management (AUM), commonly ranging from 0.5% to 2%. The expense ratio is deducted daily before calculating the fund’s NAV (net asset value). It includes various expenses like Investment management fees, sales and marketing expenses, registrar fees, and others, which we will discuss in the upcoming sections. 

How does the Expense Ratio work?

Let’s say you invested ₹10,000 in a mutual fund and it charges 1% as an expense ratio.  

A 1% expense ratio would mean that the Mutual fund would charge Rs 100 (1% of  ₹10,000) annually as an expense ratio. 

A high expense ratio would mean less return for the investor. The expense ratio depends on various factors, which we will discuss later in this article.

What is the Expense Ratio formula?

Expense Ratio = Total expense / Average asset under management

• Total expenses include investment management fees, administrative, sales and marketing expenses, registrar, audit, and custodian fees.
• Average Assets under management is the average amount of money invested under the fund during a specified period, such as yearly. 

If a mutual fund has total annual expenses of ₹1 crore and net assets of ₹100 crore, its expense ratio would be:

Expense Ratio = 1 crore / 100 crore = 0.01 = 1%

What is included in the Expense Ratio?

• Investment management fees: Fees charged by a mutual fund house for investment management, which include payment for research staff, fund managers, investing tools, and other resources. 
• Sales & marketing/advertising expenses: Expenses for sales and promotional activities of the mutual fund, such as brokers' and financial advisors' fees for selling the fund.
• Administrative expenses: These include overheads such as office operations, admin staff, and reporting. 
• Registrar fees: Fees paid to the registrar/ transfer agent to maintain a record of the fund’s investor account and transactions. 
• Custodian fees and Audit fees: Include fees paid to the custodian for the safekeeping of assets and to the external auditor for auditing the fund. 

What are the factors affecting the expense Ratio?

• Size of the fund: As the mutual fund grows, it achieves economies of scale. The fixed expense (audit, legal, admin) is spread across a large base. Therefore, the larger the fund’s AUM (assets under management) lower the expenses per unit and in turn the lower the expense ratio. In short, funds with high AUM will have a lower expense ratio.
• Regular fund vs direct fund:  Regular funds are distributed through brokers, agents, and financial advisors, and mutual funds provide commission to them. Mutual funds pass this commission to investors in the form of a high expense ratio. On the other hand, direct funds have no such intermediaries involved and therefore lower expense ratio. You can buy direct mutual funds from INDmoney with 0 commission. 
• Active management vs Passive management: Active management funds require more research, analysis, and trading, as they are trying to beat the performance of an index. This led to high investment management expenses and, therefore high expense ratio. Passive management funds, on the other hand, mimic the performance of a benchmark; therefore require fewer resources and, in turn, lower expense ratio compared to actively managed funds.
• Type of Mutual fund: Expense ratio varies across asset classes as well as sub-asset classes. For the context, an equity mutual fund would have a higher expense ratio than a debt mutual fund. In an equity mutual fund, a small-cap fund has a higher expense ratio compared to a large-cap fund. 

Impact of Expense Ratio on returns

The expense ratio can significantly reduce a fund's returns over the longer term. The lower the expense ratio, the higher the net returns to investors. 

Let's compare 2 two funds to understand the impact. 

Fund A and Fund B generate the same 12% return before expenses. Fund A has an expense ratio of 2%, while Fund B has 1%. 

The net returns to investors would be:

• Fund A: 12% - 2% = 10%
• Fund B: 12% - 1% = 11%

This might seem small in the beginning, but this difference in returns can significantly compound over time. For example, if you invest ₹1 lakh in each fund for 10 years, assuming a constant 12% gross return, the difference in net returns would be:

• Fund A (2% expense ratio): ₹2.59 lakhs
• Fund B (1% expense ratio): ₹2.83 lakhs

The ₹24,332 difference highlights the importance of considering expense ratios when selecting mutual funds.

Expense Ratio limits in India

The Securities and Exchange Board of India (SEBI) has set limits on the maximum expense ratios that mutual funds can charge. These limits vary based on the fund's assets under management (AUM) and category. 

The current limits are as follows:

In addition, mutual funds can charge an additional 30 basis points (0.30%) if new inflows from retail investors in B30 (beyond the top 30) cities are at least 30% of gross new inflows in the scheme or 15% of the scheme's average AUM, whichever is higher.

What is a good Expense Ratio?

There is no 1 word answer to it because it depends on various factors, but when comparing expense ratios, it's important to consider the following:

1. Fund category: Compare funds within the same category, as expense ratios can vary significantly across different categories of funds.
2. Direct vs regular plans: Direct plans typically have lower expense ratios than regular plans, as they don't involve intermediaries. Always consider investing in a direct plan instead of a regular plan. You can invest in direct mutual funds with Indmoney.
3. Peer group average: Compare a fund's expense ratio to the average of its peers to understand if it's higher or lower than the average. For example, if you are looking to invest in a small-cap mutual fund, consider the expense of the top 10-15 small-cap mutual funds. This way, you can come up with an average number, and then you can decide further.
4. Other factors: While expense ratio is important, it shouldn't be the sole factor in selecting a fund. Also consider the fund's performance, risk profile, and alignment with your investment objectives. A fund with a lower expense ratio, but if not aligned with your interest is not a good investment option.

Conclusion

Expense ratio is a crucial factor to consider when investing in mutual funds. A high expense ratio can significantly impact your return over the longer term. A lower expense ratio means the fund takes less out of returns each year, allowing more of your investment to remain in the fund and compound over time. However, it should not be the only factor to consider when selecting a fund. Evaluate the fund's performance, risk profile, and alignment with your investment goals before investing.

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