What is Expense Ratio in Mutual Funds - Formula, Meaning, & How to Calculate

The mutual fund expense ratio is the annual fee charged by exchange-traded funds (ETF) or mutual fund firms. In simpler words, it is the cost per unit for managing and operating your mutual fund. Here you can get a detailed idea about the cost of mutual fund investment in detail in the following sections.

Expense Ratio: What is It? 

The expense Ratio is the percentage that indicates how much you pay the AMC (Asset Management Fund) to manage your investments. It includes annual operating costs such as advertising costs, allocation charges, management fees, taxes, custodial services and other operating expenses.

Based on the type of fund the expense ratio may vary. For instance, the expense ratio of a regular fund is comparatively higher than a direct fund. The expense ratio is taken out of your investment every year following which the Net Asset Value (NAV) is published so that you do not feel the pinch.

But considering long-term gains, it can create a big difference in your investment profitability. The Securities and Exchange Board of India (SEBI) has issued rules stating that an equity fund’s expense ratio cannot exceed 2.5%, while a debt fund’s expense ratio can go as high as 2.25%.

Components of Expense Ratio

Before investing in a mutual fund, investors must have a complete idea about the costs involved and their breakups. These charges are shown through a statement every 6 months, indicating the amount deducted from the account of the investors in order to meet these costs. 

There are three significant components of the expense ratio:

    Administrative Costs

Administrative costs are the expenses incurred for running the fund operations. This includes customer support and service, keeping records, information emails and other ways of communication.

    12-1b Distribution Fees

This signifies the cost of the mutual fund's promotion and advertising process. Information about how to build a sufficient asset base must be disseminated to the masses. In this regard, mutual funds have added these promotional charges to the expense ratio.

     Management Fees

It is the cost allocated towards the payment of the individuals responsible for the smooth operation of a mutual fund. Fund managers devote their considerable time to making calculated predictions through rigorous market research so that they can generate optimum returns for respective investors. A mutual fund’s management fees typically amount to 0.5% and 1% of the total asset base.

Illustration Showing How the Mutual Fund Expense Ratio is Calculated

The expense ratio is typically calculated in terms of the percentage of the average weekly net asset of the fund. Here is the complete process of calculating this expense ratio:

Expense Ratio = Operating Expenses/Average Value of Fund Assets

In this above scenario,

Operating expenses signify the cost incurred by AMC like distribution expenses, fund manager's fees, etc.

The average value of a fund asset represents the total value of all investors’ money in that particular fund.

For a proper understanding of the given formula let us consider an example:

Assuming a equity mutual fund scheme with Asset Under Management is ₹700 crore, and the expenses it bears are up to ₹14 crore.

Therefore, expense ratio = ₹14 Cr/ 700 Cr = 2%.

The above-mentioned figure implies that in a year you will have to pay 2% as the expense ratio to the AMC. This percentage amount is deducted every year until you have invested in the scheme.

Importance of Expense Ratio

The fund house’s costs of hiring a fund manager are covered by the expense ratio. The allocation and management of funds are the sole responsibility of the fund manager. So before disbursing the profit to investors, expense ratios are generally subtracted from total revenue generated by a mutual fund. Most of us fail to realise that even small difference in the expense ratios can create a significant impact on net investment profits.

The higher the expense ratio, the lower will be your returns. Therefore, a small alteration in the expense ratio can levy a burden on annual returns earned. For instance, suppose you invest ₹20,000 in a fund scheme with an expense ratio of 2%, then it implies that you need to pay ₹ 400 to the fund house for smooth management of your money, irrespective of whether the returns are negative or positive. Similarly, a higher expense ratio will not imply that it is a suitable mutual fund. A fund with a lower mutual fund is equally capable of generating higher returns. 

On the other hand, if you are looking to invest in two similar funds, the expense ratio can play a significant role in your deciding which fund to invest in. For instance, suppose you are looking forward to two equity funds X and Y with similar investment objectives and holdings, but the expense ratio for X is 1.5% and Y is 2%. In such a case your choice will clearly be fund A.

As expense ratio directly impacts your annual returns earned, so it is crucial to carefully analyse the same while choosing a suitable mutual fund scheme.

Expense Ratio Limit by SEBI

To protect the interests of investors and ensure a considerable flow of financial resources to the capital market of the country, SEBI imposed certain restrictions. As per SEBI regulation for mutual fund, the total expense ratio that is allowed is 2.5% for the first ₹100 crore of average weekly total net assets. Similarly, for subsequent asset value of ₹300 crore, the TER deductible is a maximum of 2.25%, while 2% can be charged on subsequent slabs that cover the remainder of the asset's value.

In addition, SEBI allows all mutual funds to charge 30 basis points (0.30%) more as an incentive for selling beyond smaller towns (B15 Cities). Besides, these cities can enjoy exit load charges of 20 basis points as an additional benefit.

Final Word

It is evident that investors of mutual funds and ETFs need to know about the amount they are paying for funds to make an informed financial decision. A fund with a high mutual fund expense ratio can levy a burden on your annual returns earned. Therefore, it is crucial to analyse the same while choosing a suitable mutual fund scheme to invest in.