What is an expense ratio?
The expense ratio is the yearly maintenance fee price levied by mutual funds to manage your money. It is the rate of assets due to the asset management company (AMC). It includes operating costs, management fees, advertising costs, and allocation charges. Let’s learn more on the subject.
The article covers:
- Expense ratio meaning
- What are some major components of an expense ratio?
- What is the effect of the expense ratio on fund returns?
- Expense ratio implications
- Expense ratio limit by SEBI
- Illustration on expense ratio
Expense ratio meaning
The expense ratio states how much you pay a fund as a percentage of your investment every year to manage your money. The majority of these charges are investment and advisory fees. Aside from this, some other fund management expenses like marketing and selling expenses include agents’ commission, transaction cost, audit fee, custodian fees, costs linked to investor communication, and more.
However, in conditions of large-cap mutual funds, the amount reserved for meeting the expenses is considered a small subject to the total value of the asset. Therefore, mutual fund expense ratios have an inverse relation with the size of any specific mutual fund.
The mutual fund expense ratio’s value can be depicted using the expense ratio formula, which states that the total expenses when divided by the fund’s total assets, gives the expense ratio. Therefore, if your asset base is higher, the ratio will be lower, provided the total costs remain the same.
Expense ratio = Total expenses/total assets = 1.5/1 = 1.5% of the total investment value
What are some major components of an expense ratio?
The working and management of mutual funds is a complex task. Several factors play a significant role in the success of its performance. First, investors keep a record of all information and costs related to mutual funds to ensure transparency. Second, the charges are revealed through a statement after every 6 mth to depict the amount deducted from various investors’ accounts to cover the costs.
Different charges that are available in consideration of mutual fund expense ratio are:
- Management fees: The charge of management fees is allocated as a payment to the people responsible for operating a mutual fund. Several funds and portfolio managers regularly spend a considerable amount of time and effort determining the profits in investment opportunities. This research is done using strict market analysis and calculations of predictions. According to the research, approximately 0.5%–1% of the total base of assets is deducted as management fees of a specific mutual fund.
- Expenses for maintenance: The total cost calculated for smooth and hassle-free operations of various duties of the administration are added to these expenses. For example, maintenance of proper records of several investors, exit and entry fees of portfolio assets, and customer support services are calculated under the maintenance costs of a specific mutual fund.
- 12B-1 expenses: It is represented by the amount spent on the promotions of any specific mutual fund. Creating an appropriate asset base always requires certain 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 essential component of expense ratios.
- Exit load: It refers to the total amount payable by you when you choose to withdraw from any specific mutual fund. This charge is calculated on the total investment of a particular person. Exit load is also sometimes used to discourage investors from backing off from a particular mutual fund.
- Entry load: It is the cost that is to be paid by an investor who has joined a mutual fund. It also reduces the total income over which an investor gains interest. Various mutual funds have different charges on the entry. According to the recent Securities and Exchange Board of India (SEBI) regulations, the entry load gets abolished from the total calculations of the expense ratio of a respective mutual fund.
- Brokerage fees: Mutual funds are categorized into 2 types of plans—direct and regular. In regular plans of mutual funds, an AMC usually gets in contact with a broker to conduct all the transactions and processes related to the purchase and sale of various shares of the portfolio asset. Conversely, direct mutual funds process these transactions by themselves. Brokerage fees help in the addition of the expense ratio of a regular plan of a mutual fund; the direct funds do not have to face this burden. The expense ratio also depends on the maturity and duration of a mutual fund.
What is the effect of the expense ratio on fund returns?
Mutual fund expense ratios are most commonly deducted from the overall revenue generated by a specific mutual fund; this process is done before allocating these funds to the investors. Therefore, mutual fund expense ratios that are higher indicate a high proportion of the returns that are being removed. Any investor should properly analyze these points before selecting a mutual fund scheme for investment.
Expense ratio implications
A common misconception is that a higher expense ratio will indicate a better management process of any mutual funds. In contrast, well-trained managers manage mutual funds with a lower value of mutual fund expense ratio, but market predictions can also bring a high value of returns. Therefore, mutual funds with a higher value of expense ratio can be actively managed to produce a higher profit.
Expense ratio limit by SEBI
Mutual fund expense ratios regulated by a company that manages assets on their respective mutual funds are related to some specific restrictions imposed by the SEBI; these restrictions are made to protect the interests of investors. Additionally, it helps ensure a proper flow of resources related to financing and the country’s capital market.
These restrictions and rules are different for exchange-traded and index funds. For example, in the case of an inceptive asset base of around Rs. 500 crores of a mutual fund, an expense ratio of a maximum of 22 is charged. For another Rs 250 cr, a ratio of 1.75% is charged. According to the 52 Section of the SEBI open-end regulations, a company that manages assets can charge a maximum of 2.5 %. You should also have a look at the details of the scheme to know about the total expense ratio (TER).
Illustration on expense ratio
For example, you have invested Rs 50,000 in a mutual fund with an expense ratio equal to 2%. You are paying the fund house for Rs 1,000 for proper management of money. If the fund earns 10% and has 2% of the total expense ratio, it gives an 8% return.
For example: If the fund is handling an amount of Rs 10 lakh in assets and is collecting Rs 15,000 in its fees and additional charges are collected from various fundholders, then the mutual fund’s expense ratio is 1.5%.
It is important to do comprehensive research and know the expense ratio before investing in mutual funds. You should make efforts to get the maximum profit from your investments. Therefore, it becomes important to check the mutual fund expense ratio before investing. Moreover, you should read the scheme information document thoroughly to look at all the expenses you are being charged for. A good fund gives you a good output along with optimal expenses.
Now that you have understood the expense ratio meaning, the next question is, which platform should you choose to invest in mutual funds? Although the expense ratio is important, it is not the only criteria while picking a mutual fund scheme. A scheme with a consistently trustworthy track record may tell you differently about the TER. Sometimes, the higher mutual fund expense ratio can dominate the fair returns. Regardless, you can track the expense ratio of mutual funds on Tickertape.