Expense Ratio in Mutual Fund

What is Expense Ratio in Mutual Funds?

Expense ratio is the annual fee that a mutual fund charges to cover its operating costs. These include payments to the fund manager for their expertise, administrative expenses like record-keeping and customer service, marketing fees, and other operational costs like legal and audit fees. So, if the expense ratio in mutual funds is 1%, ₹1 out of every ₹100 you invest goes towards these expenses each year.

In mutual fund investing, the expense ratio depends on whether you choose a direct or regular plan. Here’s how they differ:

• Direct Plans: Investors purchase units directly from the Asset Management Company (AMC), bypassing intermediaries. These plans have lower expense ratios since they don't include distribution fees.

• Regular Plans: These plans involve intermediaries like brokers or financial advisors. The expense ratio is higher due to the inclusion of distribution fees.

Why the Expense Ratio in Mutual Funds Matters?

The expense ratio is an essential factor when choosing a mutual fund. Here’s why it matters and how it affects your returns:

• Impact on Returns: A higher expense ratio reduces your overall returns. For example, if a fund offers a 6% return but has a 2% expense ratio, your net return would be 4%.

• Cost Efficiency: Funds with lower expense ratios are more cost-efficient, allowing more investment to grow. Lower expense ratios mean more of your money stays in the fund, helping it grow faster.

• Performance Comparison: It’s important to compare the expense ratios of different funds when making a decision. Actively managed funds generally have higher expenses, while passively managed funds, like index funds, usually have lower expenses.

• Long-Term Impact: Over many years, even a small difference in the expense ratio can make a big difference in your investment returns. A higher expense ratio can cost you more in the long run, even if the difference is just 1%.

How is the Expense Ratio in Mutual Funds Calculated?

The mutual fund expense ratio is calculated by dividing the fund’s total operating expenses by its average assets under management (AUM). This percentage indicates the portion of the fund’s assets used for expenses and is factored into the fund’s returns. Here’s an overview of the expense ratio formula:

Expense Ratio (%) = 

(Total Operating Expenses / Average Assets Under Management) × 100

So, if a mutual fund has:

• Annual Expenses: ₹10 lakh

• Average AUM: ₹100 crore

The expense ratio would be:

(₹10,00,000 / ₹100,00,00,000) × 100 = 1%

Note: The expense ratio is not charged separately; instead, it is included in the fund's Net Asset Value (NAV). Your returns are calculated after the expense ratio has already been deducted.

Components of the Expense Ratio in Mutual Funds

The expense ratio consists of several components, each contributing to the overall cost of managing a mutual fund. Here’s a breakdown of these components:

• Management Fees: These fees are paid to the fund manager for their expertise in managing the fund’s portfolio. Fund managers are responsible for making investment decisions, selecting stocks, bonds, or other assets, and adjusting the fund’s strategy based on market conditions. 

• Administrative Costs: These costs cover the fund's day-to-day operations. This includes maintaining records, processing transactions, handling customer service inquiries, and ensuring compliance with regulations. 

• Marketing and Distribution Fees (12b-1 Fees): These fees are associated with promoting and selling the fund to potential investors. They include advertising, sales commissions paid to brokers, and other marketing expenses. 

• Other Operational Expenses: These are additional costs needed to keep the fund running, such as legal fees, audit costs, and compliance with regulatory standards.

• Brokerage Fees: Applicable in regular plans where brokers handle purchase and sale transactions of portfolio assets. Direct mutual funds avoid these costs, lowering their expense ratio.

• Exit Load: A fee charged when investors redeem units before a specified holding period, usually 2–3% of the withdrawn amount. While this is not included in the expense ratio, it affects the overall cost of investing.

Regulatory Limits on Total Expense Ratio in Mutual Fund

In India, the expense ratio is fungible, meaning there is no cap on any specific type of allowed expense as long as the total expense ratio stays within the limits. These limits are prescribed by the Securities and Exchange Board of India (SEBI) under Regulation 52 of the SEBI Mutual Fund Regulations.

Effective April 1, 2020, SEBI revised the TER limits for mutual funds as follows:

How to Compare Expense Ratio in Mutual Funds?

When comparing mutual funds, consider the following factors:

• Fund Type: Actively managed funds typically have higher expense ratios than index funds. This is because actively managed funds require more research and management by the fund manager, whereas index funds are passively managed and simply track a specific market index.

• Fund Performance: A higher expense ratio may be justified if the fund consistently outperforms its benchmark. While lower expense ratios are generally preferred, funds that offer higher returns over time might justify the higher costs, especially if the extra fees lead to significantly better performance.

• Investment Horizon: Over long periods, even small differences in expense ratios can lead to significant return variations. This is due to the compounding effect, where the expenses are deducted from your investment each year, and the impact becomes more pronounced over time.

Taxation on Expense Ratio in Mutual Funds

Even with a low expense ratio, taxes directly impact your net returns. Knowing how equity, debt, hybrid, and other mutual funds are taxed is essential for making informed investment decisions.

*New Taxation Rule applicable w.e.f July 23, 2024

Key Takeaways

A lower expense ratio means fewer fees are taken from your returns, allowing more of your money to grow. This is especially critical if you're investing through a Systematic Investment Plan in India, as the expense ratio in SIP impacts your returns with every monthly contribution. Therefore, considering the nuances of expense ratios when choosing mutual funds ensures you get the best value.