8 min read • Published 5 Dec 24
Mutual Fund Expense Ratios: What you should know
Table of Contents
A mutual fund expense ratio is the percentage that shows how much it costs to run and manage a mutual fund each year compared to the total amount of money invested.
Mutual funds are a popular choice for their diversification and expert management.
The expense ratio includes fund running expenses, including professional management, administrative charges, and marketing initiatives. Although this indicator seems small, it directly affects net returns. It reveals how much of an investor’s money is allocated to operational costs.
This article explains mutual fund expense ratios in detail, explaining their meaning, how they’re calculated, and what they mean in the real world. Read on!
An expense ratio of 1%, for example, means that every ₹100 invested in the fund deducts ₹1 yearly. Though the deduction seems small, its compounding effect can majorly impact long-term results over time.
For instance, if an investor puts ₹10,000 in a mutual fund with a 1.5% expense ratio, a daily deduction of about ₹0.41 will be made. Although this daily deduction seems small, it adds up over time and reduces the total gains.
What Does the Expense Ratio Cover?
The expense ratio is a measure of all the costs that come with running a mutual fund, such as:
- Investment Management Fees: Compensation for fund managers in charge of choosing and managing investments in the portfolio
- Administrative Costs: Record-keeping, compliance, auditing, and customer service.
- Marketing and Distribution Fees: Many refer to marketing and distribution fees as 12b-1. These fees pay for advertising, promotions, and broker commissions.
- Others: Miscellaneous costs that are needed to keep the fund running, such as transaction fees and security fees.
Each component helps to give a clear picture of how much investors pay for the fund’s services.
How Is the Expense Ratio Deducted?
The fund calculates expense ratios annually, deducting them from its assets daily. This ensures buyers pay their fair share of the costs based on ownership.
For example, if a fund has an expense ratio of 1%, a small percentage is deducted daily from the fund’s net asset value (NAV).
The expense ratio is calculated using the following formula:
Expense Ratio (%)= (Total Annual Operating Expenses/Average Net Assets)×100
For instance, the expense ratio is as follows if a mutual fund has average net assets of₹100 crore and yearly operating expenses of₹2 crore:
(2 crore / 100 crore)×100=2%
This means 2% of the investor’s assets will be deducted annually to cover the fund’s costs.
Types of Funds and Their Expense Ratios
The expense ratios of different types of mutual funds are mostly based on how they are managed and their financial goals.
Here are the main types of mutual funds and how their expense ratios compare:
1. Actively Managed Funds
The goal of actively managed funds is to perform better than market standards by actively choosing stocks and managing their portfolios. These funds usually have higher expense ratios because they require extensive study, analysis, and trading.
2. Passively Managed Funds (Index Funds)
Index funds and other passively managed funds try to match the success of a certain market index. Since these funds don’t need much management, their expense ratios are usually lower, often below 0.2%.
3. Exchange-Traded Funds (ETFs)
Because of how they are set up and traded, ETFs usually have the lowest expense ratios of all mutual funds. Their low operating costs make them a good choice for investors who want to save money.
4. Debt Funds
Debt funds, which mostly buy fixed-income assets, usually have lower expense ratios than equity funds. However, these numbers can change depending on the fund’s complexity and management.
By understanding the fee ratio, investors can find funds that offer excellent value for money and can help them reach their financial goals. Choosing funds with low expense ratios can significantly affect the growth of a financial portfolio over time.
How the Expense Ratio Impacts Returns
The expense ratio is important in calculating net returns because it is subtracted from a fund’s returns before they are distributed to investors.
This is how it affects performance:
- Erosion of Returns: A high expense ratio reduces the returns available to investors. For example, if a fund generates a return of 8% annually but has an expense ratio of 2%, the net return to the investor is only 6%.
- Compounding Effect: The compounding effect means that over time, even a small difference in expense ratios can cause returns to vary significantly. Over ten years, a fund with a 1% expense ratio will keep more profits than a fund with a 2% expense ratio.
- Risk-Adjusted Returns: Investors should consider whether a fund’s high fees are worth it because it does so well. If, after fees, an actively managed fund doesn’t do better than its standard, an index fund with lower costs might be a better choice.
Regulatory Guidelines for Expense Ratios in India
In India, the Securities and Exchange Board of India (SEBI) regulates mutual fund expense ratios to protect investors and ensure transparency. These guidelines set maximum permissible limits on the Total Expense Ratio (TER) based on the fund’s Assets Under Management (AUM) and type.
SEBI’s Expense Ratio Caps:
SEBI’s regulations specify the following maximum TER limits for mutual funds:
| AUM Bracket | Equity-Oriented Schemes | Other Than Equity-Oriented Schemes |
| Up to ₹500 crore | 2.25% | 2.00% |
| Next ₹250 crore | 2.00% | 1.75% |
| Next ₹1,250 crore | 1.75% | 1.50% |
| Next ₹3,000 crore | 1.60% | 1.35% |
| Next ₹5,000 crore | 1.50% | 1.25% |
| On the next ₹40,000 crore | Reduction of 0.05% for every increase of ₹5,000 crore or part thereof | Reduction of 0.05% for every increase of ₹5,000 crore or part thereof |
| Above ₹50,000 crore | 1.05% | 0.80% |
These tiered structures encourage fund houses to pass on the benefits of economies of scale to investors as the fund’s AUM grows.
Additional Provisions
- Beyond Top 30 Cities (B30) Incentive: Mutual funds can charge an extra TER of up to 0.30% if new inflows from retail investors outside of the top 30 cities make up at least 30% of the scheme’s gross new inflows or 15% of its average AUM, whichever is higher.
- Direct Plans: Introduced in 2013, direct plans exclude distribution expenses and commissions, resulting in lower TERs than regular plans.
Key Considerations When Evaluating Expense Ratios
The expense ratio is important when choosing mutual funds, as it helps find the most cost-effective options. However, the expense ratio should not be considered by itself.
Here are some important considerations for investors to remember:
1. Fund Performance
While a lower expense ratio is desirable, it should not come at the cost of underperformance. Investors should analyse a fund’s risk-adjusted returns over multiple years to determine whether its performance justifies the price.
2. Investment Horizon
Expense rates have a bigger effect over time. Even small changes in expense ratios can cause returns to vary significantly in long-term investments. Investors who want to build wealth over time should choose funds with competitive rates.
3. Assets Under Management (AUM)
Funds with a larger AUM tend to have lower expense ratios. This is because of economies of scale. Check if the fund’s size allows it to continue operating with a reasonable expense ratio.
4. Benchmark Comparison
Compare a fund’s expense ratio to its type’s average or benchmark index. Funds with much higher ratios than their peers should have proportionally higher yields to compensate for the extra cost.
5. Hidden Costs
While the expense ratio is the most visible cost, additional fees such as exit loads, sales loads, and redemption fees should be considered. These costs can impact net returns and should be factored into decision-making.
Wrapping Up
Investors who want to make smart choices about costs and get the best returns must understand the mutual fund expense ratio. This metric, which is sometimes forgotten, can greatly affect the growth of an investment portfolio. A lower expense ratio means more money stays invested and grows over time.
Investors should approach financial goals holistically by assessing aspects such as fund type, performance, and investment horizon. For smarter investment insights, explore the PowerUp Money app, which is meant to simplify financial decisions and promote long-term wealth growth.
The information contained in this article is intended solely for informational purposes and should not be interpreted as legal, tax, or financial advice. PowerUp is not liable for any errors, omissions, or outcomes that may arise from using this information, even though every effort has been made to ensure its accuracy.
Q: What is considered a good expense ratio for mutual funds?
A good expense ratio depends on the fund type. For actively managed funds, an expense ratio below 1% is ideal. For passively managed funds like index funds or ETFs, it is preferable to have an expense ratio below 0.2%.
Q: Do expense ratios affect returns directly?
Yes, expense ratios are deducted from a fund's assets, reducing the returns distributed to investors. For example, if a fund earns 10% but has an expense ratio of 2%, the investor's net return is only 8%.
Q: How often are expense ratios updated?
Expense ratios are typically updated annually and disclosed in the fund's fact sheet. However, changes may occur if the fund's operating costs or AUM fluctuate significantly.
Q: Are lower expense ratios always better?
While lower expense ratios reduce costs, they should be evaluated alongside the fund's performance. A higher-cost fund may justify its expense ratio through better returns.
