A lot of questions like “what is an expense ratio? How is it charged? How does an asset management company make money?” etc. rise in our minds every now and then. Expense ratio or something also known as total expense ratio is the fee charged by the mutual fund for managing investors’ fund. This is a single charge that includes all the expenses required to run a mutual fund. For example, the registrar fee fund management fee, distributor’s commission, advertising expense, auditor and custodian’s share etc. are some of the fees charged by mutual funds.
What is an Expense Ratio?
Expense ratio is charged as a percentage of your assets under management. It is expressed as an annual figure but charged on a daily basis. NAV (net asset value) in case of mutual funds is calculated after deducting the expense ratio, i.e. all the expenses related to running a mutual fund. So, NAV based returns that you see in case of mutual funds are your actual returns. Unlike ULIPS (Unit Linked Insurance Plans) wherein NAV is calculated only after deducting the fund management charges and then onwards a huge array of charges is levied which is recovered by deducting your units.So, NAV based returns in ULIPS don’t give you a clear idea of the kind of returns you have earned while NAV based returns on your mutual funds are your actual returns.
Let me give you an example, let us say you invested Rs.1 lakh in a mutual fund which had an expense ratio of 2%. So in a year, you are paying Rs.2,000 to the mutual fund for managing your money or you could say in that year if the mutual fund earned 10% returns on your investment, it would keep 2% to itself and pass on the remaining 8% to you. But remember, expense ratio is recurring and irrespective of the fund makes profit or loss, expense ratio would be charged.
It would not be wrong to say that the mutual fund industry is one of the most transparent, most well regulated industries and the same is evident from the way expense ratio is charged and how things are kept transparent through the NAV. Stock exchange watchdog SEBI (Securities Exchange Board of India) has put an upper limit on the amount of expense ratios that can be charged. For equity mutual funds, it is 2.5% and for debt mutual funds, it is 2.25%. Mutual funds can take an additional expense ratio of 0.3% if 30% of the inflows come from cities and towns which are a not a part of top 15 locations in the country. This incentive is given so that mutual funds can penetrate smaller cities and towns.
Is the expense ratio same for every investor?
Expense ratio for every investor is charged equally irrespective of the time they invest in the scheme, whether they invest in an NFO (new fund offer) or an already existing fund. The mutual fund has the right to change the expense ratio over a period of time but would still stay under the ceilings imposed by SEBI. Newer funds would generally have a higher expense ratio over the older, already established ones.
Should you care about expense ratio in mutual funds?
Equity and debt funds have different slabs on which expense ratio is charged. In equity funds, the good funds would give superior returns than the average ones and the difference between the expense ratio would not be much. In that case, you should select the fund which gives you superior returns. But if you are considering two funds for investment, which are same in all respects like returns, risk returns parameters etc, but only differ in terms of expense ratio, then you should choose the one that has a lower expense ratio. In debt funds, returns in every category are generally similar so expense ratio becomes a differentiating factor. After comparing returns within a category you should go for a fund that has a low expense ratio.
There are direct and regular plans of the same mutual fund. The regular plans have higher expense ratio as they come through distributors and a portion of the expense ratio, compensates the distributor for his advice. Direct plans generally have low expense ratio as there is no intermediary involved. You should go for a direct plan only if you are experienced and do not need anyone to guide you. However, it is always a good idea to consult a professional because the know more about mutual funds. Don’t forget that “mutual fund investments are subject to market risks, read the offer document carefully before investing”.