What is mutual fund expense ratio?

If you are investing in mutual funds, you need to be aware of expense ratio and how that will affect your returns

Kavya Balaji   /   February 18, 2020
mutual fund expense ratio

You searched for the best performing mutual funds and are ready to invest. Wait! Have you checked its expense ratio? This is a mutual fund parameter that will help you check if the fund is being managed well. Note that a higher expense ratio could mean lower returns from the fund. Before we get to that, hereís what you need to know about the expense ratio of a fund.

What consists of expense ratio

A fundís expense ratio measures the cost of managing the fund. It is expressed on a per unit basis. The formula for the ratio is the fundís total expenses divided by the amount of assets that the fund is managing. In simple words, an expense ratio is the amount companies charge you, the investor, to manage the mutual fund.

Now, what are these expenses that a fund has to manage? Fund houses employ professionals for running the business. So, there you have the management fee. Then there are expenses for running the fund such as transfer fee and fees for registrar agents who are the entities that help in issuing mutual fund units and redeeming them. Other expenses include custodian charges, legal expenses and auditing expenses. It doesnít stop there. Then there are marketing charges and distribution expenses. So, all these expenses together are expressed as a percentage of the fundís assets. However, the amount of money that the fund house spends for trading, that is buying and selling of stocks and bonds, is not included in the expense ratio.

So, using the expense ratio, the fund is trying to recover all its costs from you. The ratio is calculated by the fund house and is published in its mutual fund reports twice a year.

How does it work?

Suppose you have found a mutual fund whose NAV is Rs 10.  You are investing Rs 2 lakhs in this mutual fund. Letís say the expense ratio is 2%. Assume that you have got a return of 11% from the mutual fund after a year. So, the value of your investment will be about Rs 2.2 lakhs. However, after the expense ratio has been deducted, the value of your investment will be only Rs. 2.18 lakhs. So, you actually earn less because of a higher expense ratio.

What is a good ratio?

Whether an expense ratio is good or bad will depend on the type of fund you have chosen. For equity funds, the expense ratio might not have as much of an impact as for a debt fund. This is because debt funds give you single digit returns while equity funds usually give double digit returns. For debt funds, the expense ratio of the fund is crucial. Consider this: a debt fund is giving you a return of 7% every year. If the expense ratio for the fund is 2%. Your actual returns will be just 5%, which is not great. That is why you need to look for funds with a low expense ratio.

Is there a limit to these ratios?

The Securities Exchange Board of India (SEBI) has put in ceiling limits for expense ratios of mutual funds. If it is an open-ended equity fund, the fund house is allowed to have a maximum of 2.25% as the expense ratio. The figure is 2% if it is a debt fund. SEBI has said that the expense ratio of the fund will vary based on the Assets Under Management (AUM) of the fund. Hereís the table for equity funds.

AUM (Rs. Crores)Maximum expense ratio (%)
0-5002.25
500-7502
750-20001.75
2000-50001.6
5000-100001.5
10000-50000TER reduction of 0.05% for every increase of 5,000 crore AUM or part thereof
More than 50,0001.05

Source: SEBI

Which funds have low expense ratios?

Index funds will typically have a low expense ratio because of their nature. These are funds that mimic an index and there is no strategy needed for managing these funds. So, the expenses for these funds are low.

Expense ratio for direct plans are lower. In a direct plan of a mutual fund scheme you buy directly from the mutual fund company, whereas in a regular plan you use the services of an advisor or distributor. The mutual fund company has to pay commission to the distributors in case of regular plans. This is added to the expense ratio. Hence, the expense ratio is higher for a regular plan.

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