Every good or service you purchase has a cost. Mutual funds are the same. Different types of mutual funds are provided to investors by Asset Management Companies (AMC) or fund houses, and each fund is managed by a professional. And for managing your money, mutual fund houses charge a small amount. This cost is charged as a fee termed as expense ratio.
What is an expense ratio?
The expense ratio is a percentage used to indicate how much is AMC charging you to manage your investments. In other terms, it represents the expense per unit incurred to operate and manage the mutual fund.
A fund’s expense ratio is determined by dividing the entire fund fees—including operating and management fees — by the total fund assets. The prospectus of every fund and most financial websites includes an expense ratio table.
Expense ratio = Fund’s net operating expenses / Fund’s net assets
Let’s imagine that an equity mutual fund scheme has Assets Under Management (AUM) of Rs 700 crore and incurs charges of Rs 14 crore for the fees listed above.
The expense ratio as per the formula will then be = Rs 14 Cr/Rs 700 Cr
This suggests that each investor must provide the AMC 2% yearly expense ratio. This amount is charged and adjusted in the Net Asset Value (NAV) daily.
Why is the expense ratio important?
- The expense ratio of a fund is crucial because it informs investors of the costs associated with participating in a particular fund and the amount by which the returns will be diminished. The expense ratio should be as low as possible because this indicates that you will receive higher returns on your investments.
- A greater expense ratio does not necessarily indicate a superior mutual fund. A fund with a less expense ratio may have an equal or greater ability to generate higher returns.
- A direct mutual fund has a lower expense ratio than a regular fund. This is because traditional mutual funds are distributed by mutual fund distributors, even though you can invest in direct funds through the AMC. As a result, the distributor’s commission is included in the expense ratio. This commission could eventually result in a considerable reduction in your returns.
- Mutual funds should not have more than 1% expense ratio for major company investments and more than 1.25% for smaller company investments. There are funds with expense ratios greater than this, and you can categorise them as pricey funds or as funds with a unique service that justifies the high cost.
- You can use the expense ratio as one of the criteria to compare two or more funds. This is especially helpful if two funds of the same category have historically performed similarly.
- Since debt funds have relatively lower returns when compared to equity funds, the expense ratio has a greater influence on debt funds or mutual fund. With a 2% expense ratio, a return of 7% will drop to 5%, which is insufficient to outperform inflation.
Given the fierce competition that has led to a dramatic drop in management fees over the past ten years, high expense ratios for active funds must be justified by spectacular returns or provide investors with some other benefit. Every rupee counts when it comes to investments. Make every effort to maximise your return by carefully evaluating the expense ratio before investing in a fund.