If you are a regular investor or thinking of investing in mutual funds, it is important to gain information about how mutual funds work. During the research, you must have come across the term called ‘expense ratio’ or your financial advisor may have informed you about it while handling your investment portfolio. So what does this term ‘expense ratio’ mean? How does it affect the overall returns of your mutual fund investment? Let us try to get an in-detail understanding of it.
What is an Expense Ratio?
An expense ratio is the fees that asset management companies (AMCs) charge you for managing your investment. You can compare this to the fees a doctor charges for their services. Depending on the type of mutual fund, the expense ratio may fluctuate. To put it in simple words, it is the expense of operating a mutual fund. The financial advisor or the fund manager takes up the largest piece of the operating expenses. It becomes a part of their fees. The rest of the amount of towards managing the costs of registrar fees, legal services, accounting fees, auditing fees, custodial fees, etc. Some other operating expenses may also involve marketing costs.
The fee of expense ratio is cut from your investment daily, after which the NAV (Net Asset Value) is published. This is the reason why it doesn’t affect you on a regular basis. However, if you are looking for long-term investment (more than 5 years) then it can make a considerable difference to your returns.
As per the latest regulations by SEBI, the expense ratio for debt funds cannot be more than 2.25% whereas, for equity funds, it should not go beyond 2.5%.
Components of Expense Ratio
As mentioned above, the expense ratio involves various charges that are necessary for the seamless administration of a mutual fund scheme. The cost of this administration is recovered from the investors on a daily basis however, it is revealed only once every six months.
There are 3 major components of an expense ratio
a. Management Fees:
Mutual Funds are a refined product that requires forming critical investment strategies long before allowing investors to put in money for the underlying assets. AMCs employ fund managers for efficiently managing these mutual fund schemes. These fund managers need to have high degrees of education and experience in managing relevant mutual fund schemes along with professional credentials. The investment advisory fees or management fees are used to compensate these managers. On an average, this fee comes about 0.5% to 1% of the overall fund assets.
b. Cost of Administration:
The costs of administration are the costs associated with running and managing the fund. This includes customer support, communications, information emails, and record keeping among others. These expenses can differ greatly and are represented as a percentage of assets of the mutual fund.
c. 12-1b Distribution Fees:
Most of the mutual funds collect the 12-1b distribution fees for promoting and advertising the scheme. Most of the funds charge their stakeholders to promote as well as market the fund to the potential investors. The total of these three expenses is equal to the percentage of assets cut from the mutual fund and is called the expense ratio.
How Expense Ratio Affects Returns Generated from Investment?
Expense ratio represents the fees charged by the fund in terms of annual percentage to manage your investments. For instance, consider you invest INR 10,000 in a mutual fund scheme with an expense ratio of 2%. Then, you need to pay INR 200 to the fund to manage your investment. In other words, if the fund gives you returns of about 14% with an expense ratio of 2%, then you would generate returns of about 12%. The NAV of the mutual fund is published after subtracting all expenses and fees. Thus, it is important to understand how much you are paying to the AMC.
A low expense ratio indicates more profit and high one means less profit. Expense ratio becomes important in relation to debt funds, particularly in a world of low returns. Apart from that, you can use the expense ratio to separate actively or passively managed funds.
The alpha generated by the fund manager in the equity funds is the clear explanation of the expense ratio taxed by the fund.
The formula for Calculating Expense Ratio
Expense Ratio = Operating Expenses/Average Value of Fund Assets
Illustration of How Expense Ratios Affects Mutual Fund Returns
Let’s take an example of how an investment of INR 10,000 in SIP will perform over a period of time
* The returns are calculated at the rate of 11%
However, high expense ratio does not necessarily correspond to low returns. If the schemes are managed aggressively then higher profits can be a result of the high expense ratio. This is also because of the correct choice of investment as well as assets with good stocks.