The expense ratio of mutual funds is the annual fee charged by the mutual fund for managing investors’ money. It is a single fee that includes all the expenses required to run a mutual fund, like fund management fees, marketing and distributing expenses, legal and audit expenses, etc.
An expense ratio is charged as a percentage of your Asset Under Management (AUM). It is expressed as an annual figure but charged on a daily basis. Net Asset Value (NAV) is calculated after deducting the expense ratio i.e. all the expenses related to running a mutual fund. NAV is published daily. So, NAV based returns that you see in mutual funds are your actual returns.
Brokerage and other charges charged by mutual funds while buying and selling shares are not included in the expense ratio. And these charges are also deducted while calculating the NAV.
How to calculate the Expense Ratio?
Expense Ratio = Total Expenses / Asset Under Management (AUM)
The investors’ total amount of money invested in any mutual fund scheme is the Asset Under Management (AUM) for the mutual fund schemes. The lower the AUM of any mutual fund scheme, the higher the expense ratio of that fund, and the higher the AUM, the lower the expense ratio of that fund. The mutual fund has the right to change the expense ratio over time but would still stay under the SEBI’s ceilings. Newer funds would generally have a high expense ratio than the older established ones.
The market regulator SEBI has put a ceiling on the amount of expense ratio for every category’s mutual fund schemes. For equity mutual funds, it is 2.5%, and for Debt mutual funds, it is 2.25%. Even though this 2.5% is an annual percentage of your investment amount, it is deducted on a daily basis when it is deducted.
Impact of Expense Ratio on Returns
Suppose you have invested Rs 10,000 in a mutual fund scheme whose expense ratio is 2%, then you are paying 2%, i.e., Rs 200 on the total investment that is an expense ratio to manage your fund. If that scheme has given you a 14% return and the expense ratio of that scheme is 2%, then the actual return you will get will be 12% only. Because here, you pay a 2% expense ratio on your investment value. So, the lower the expense ratio of any mutual fund scheme, the higher is its profit and vice versa. The expense ratio is recurring and would be charged irrespective of the fund makes profit or loss.
When you invest in a new mutual fund scheme, you must consider its expense ratio because if you pay a 1% extra expense ratio, it seems very low. But when you remain invested for the long term, this can bring a massive reduction in the profit you get.
Different mutual fund schemes have different expense ratios. In Equity mutual funds, the expense ratio of actively managed funds is more than the expense ratio of passively managed mutual funds. Because in actively managed mutual funds, fund managers regularly change stocks, they do a lot of research and pick the stock himself. In contrast, in passively managed mutual funds, the fund managers do not need to do any research and not select stocks themselves. They track the indices or funds.
Any mutual fund schemes have a direct plan and a regular plan. The only difference between the direct plan and the regular plan is the expense ratio. In a direct plan, the expense ratio is less than the regular plan because there is no intermediary such as an advisor or distributor involved in the direct plan. You buy these mutual funds directly from the Asset Management Companies. But in a regular plan, a part of the expense ratio is given to the distributor for their investment advice. It would be best to choose direct plans only when you are a very experienced investor and do not need investment advice.
Conclusion
The main fee that is in the expense ratio is the Fund Management Fee. You can see any mutual fund scheme’s expense ratio from the factsheet of that mutual fund or on the mutual fund website or the websites like www.moneycontrol.com and www.valueresearchonline.com. In the long term, the expense ratio matters a lot because of the compounding effect; the expense ratio can significantly impact your returns.
It is not that mutual funds that have lower expense ratios are good. A mutual fund scheme is good or not, your investment goals are being suited or not; you will have to analyze many factors such as the performance of that scheme, the fund manager’s skill and expertise, the risk and reward factors of that scheme, etc.
It is not that once the mutual fund scheme has shown the expense ratio, it will remain the same forever. Even after your investment, the expense ratio of that scheme can change. According to SEBI guidelines, if a mutual fund scheme increases the expense ratio, it is necessary to inform the investors of that scheme.
Also Read: CAGR (Compounded Annual Growth Rate)