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A mutual fund’s return may not always be as expected because of the various costs associated with it. Though the gross return may be high, the net return after deducting all costs may be much lower.
Understanding these costs is of paramount importance when choosing a mutual fund to invest in. Today’s article discusses the different expenses in a mutual fund, calculating the expense ratio and its related components.
What is the expense ratio in mutual funds?
The expense ratio is a number that signifies the total expenses in proportion to the size of the fund. It is expressed as a percentage indicating the total fees investors must pay to the asset management company besides investing in the fund.
Asset management companies have dedicated fund managers who pool funds from various investors and manage the investment. These expenses are charges for their professional services. Every mutual fund has a different expense ratio, depending on the company’s policies.
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The fees charged depend on the fund’s size, with the two being inversely related. A large-sized fund has a lower expense ratio, while a small-sized fund has a higher expense ratio.
How does a mutual fund’s expense ratio affect the return?
The expense ratio has a direct impact on the investor’s earnings from the mutual fund. Once the mutual fund earns profits, the asset management company deducts related expenses before dispersing the gains to investors.
So, a higher expense ratio will lower the profits in hand for the investor and vice versa. Investors also need to know that a high expense ratio is not always related to a well-managed fund. Analysing the fund’s past performance and other terms is equally necessary.
Understanding the expense ratio of mutual funds is one of the first steps before investing. The percentage of expenses can be a significant factor when choosing between two similar funds. An obvious choice is the one with a lower expense ratio, provided the two funds offer identical returns.
The impact of the expense ratio may not seem severe when the returns generated are considerably high. However, it can have a large bearing on the investor’s pocket for funds generating medium returns, like debt funds.
Components of the expense ratio
The total expense ratio consists of various charges that the asset management company levies on investors. Some of them forming a significant part of the base total expense ratio are as follows:
- Management fees – It is charged by AMCs to compensate fund managers who use their expertise to manage funds and generate maximum profits.
- Maintenance fees – These include administrative expenses to maintain the fund’s records and other organisational tasks related to the fund’s supervision.
- Entry and exit load – These are charges levied on investors when they want to enter a fund or prematurely take an exit.
- Brokerage fees – Some mutual funds involve brokers, apart from the fund managers. Such funds charge investors additionally to pay the brokers.
Other funds like legal charges, advertising and marketing costs, etc., are all charged back to investors and form a part of the expense ratio.
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How to calculate the expense ratio in mutual funds?
Expense ratio formula = Sum of all expenses related to the fund / Total assets under the fund’s management.
Consider the example of a mutual fund having a total value of ₹10 crores, with a total expense of ₹2 crores. The total expense ratio of the mutual fund will be 2 crore / 10 crore = 20%.
So, an investor participating in this fund must spend 20% of the fund’s value every year towards the fund’s expenses.
The Securities and Exchange Board of India (SEBI) monitors the working of mutual funds. To protect investors from the pressure of additional charges, the SEBI has set upper limits on the charges that asset management companies can charge.
The number varies depending on the fund’s size, with the lowest expense ratio of mutual funds being 0.05% to the highest being 2.25%.
Bottomline
The expense ratio is the fees paid by investors towards managing mutual funds. It is, however, not paid by investors separately, as the amount is directly deducted from their initial investment amounts on a daily basis.
The expense ratio’s size depends on the fund’s size. A large fund has a lower ratio and vice versa. It is essential for investors to thoroughly analyse the components of the ratio and assess how it impacts their returns before making the investment.
FAQs
There is no specific number determining a good expense ratio. However, an ideal ratio is usually between 0.75 to 1.5. Anything above that is usually termed expensive.
The expense ratio is an annual charge. However, it is not charged once every year. The calculation happens per annum, but a portion of it is charged on a daily basis, by deducting the proportional value from the fund’s NAV.
The exit load is a charge levied on the premature redemption of mutual funds. It aims to discourage investors from early exits. Exit load and expense ratio are directly related. The higher the exit load, the higher the expense ratio and vice versa.
No, the expense ratio is an integral part of mutual fund transactions. Investors can look for funds with a low expense ratio, but cannot entirely avoid it.
The expense ratio is taken away from the NAV, affecting the investor’s return. A high expense ratio can take away a significant portion of returns in the long run, since it also hampers the compounding process. Hence, looking for a fair expense ratio is ideal.