What is Expense Ratio?

Investing in mutual funds is a popular way for investors to diversify their portfolios and achieve their investment goals. However, investing in mutual funds comes with costs, including the expense ratio.

The expense ratio is the annual fee a mutual fund charges to cover its operating expenses, such as management fees, administrative costs and marketing expenses. This fee is expressed as a percentage of the fund's net asset value (NAV) and is deducted from the fund's returns.

How to calculate Expense Ratio

The expense ratio of a mutual fund is calculated by dividing the total costs by the average assets under management.

Expense Ratio = (Total costs incurred by the fund) / (Average assets under management)

Here, total costs incurred by the fund would be the costs borne the assets management company. As mentioned above, these would be management, administrative and marketing expenses. 

Average assets under management or AUM is the market value of all the funds managed by the fund.

Now, let’s understand how to calculate expense ratio with an example. Say AUM or assets under management of a fund scheme is ₹5 crore and the expenses it bears is up to ₹5 lakh. In this case, expense ratio will be: 

Expense ratio: 5 crore/5 lakh = 1%

Now that we know that the mutual fund has an expense ratio of 1% and if its NAV or Net Asset Value(the price of each unit of a mutual fund) is ₹1,000, then the annual fee would be ₹10 per share (₹1,000 x 1%). If you own 100 units, your annual fee would be ₹1,000.

Why Expense Ratio Matters in Mutual Funds?

The expense ratio directly impacts your investment returns. The higher the expense ratio, the lower your investment returns will be over the long term. This is because the expense ratio is deducted from the fund's returns before they are passed on to investors. 

Let's take an example to illustrate this point. 

Suppose you invest ₹10,000 in two mutual funds, A & B. Say they have similar investment objectives and performance but have different expense ratios. Mutual Fund A has an expense ratio of 0.5%, while Mutual Fund B has an expense ratio of 1.5%. 

Assuming both mutual funds give a 10% annual return, after 10 years, your investment in Mutual Fund A would be worth ₹27,653, while your investment in Mutual Fund B would be worth ₹24,337. The difference of ₹3,316 might not seem significant, but over the long term, it can add up to a substantial amount.

How to Choose Mutual Funds Based on Expense Ratio?

When choosing mutual funds based on expense ratio, here are a few factors to consider:

1. Compare expense ratios of different mutual funds: Compare the expense ratios of mutual funds with similar investment objectives and performance. Look for mutual funds with lower expense ratios, as they are likely to  provide better returns over the long term.
2. Don’t ignore the fineprint: The expense ratio is one of many factors to consider while choosing a mutual fund. You should also consider other factors, such as the mutual fund's investment objective, asset class, historical performance, liquidity and diversification.
3. Look for tax efficiency: Mutual funds are required to distribute capital gains and income to their shareholders, which can result in tax liabilities. However, some mutual funds are more tax-efficient than others, depending on their investment strategies. Look for mutual funds that are designed to minimise taxes.
4. Keep an eye on the total cost of ownership: The expense ratio is just one component of a mutual fund's total cost of ownership. Other costs, such as transaction costs, sales loads and account maintenance fees, can also impact your investment returns. Therefore, it's important to consider the total cost of ownership when choosing a mutual fund.

In conclusion, the expense ratio is a crucial aspect to consider when choosing a mutual fund, as it can significantly impact your investment returns over the long term. By comparing the expense ratios of different mutual funds and other factors, you can make informed decisions that align with your investment goals and risk tolerance.