Expense Ratio in Mutual Fund: Meaning, Calculation & Components

Today, a larger population has become financially prudent and makes various kinds of investments. With the rise of fintech, investing has become extremely convenient for everyone. Mutual funds are a popular investment option for investors because they tend to give relatively high returns than other investment options like fixed deposits and carry a slightly lesser risk than some equity investments. However, they also carry some additional expenses.As an investor, it is important to understand each aspect of the investment to make accurate calculations of the returns. Through this article, investors can learn everything that they need to know about the expense ratio of a mutual fund.

A mutual fund is a group of assets (like securities of different companies) that is maintained by asset managers. To keep tabs on these assets and maximize the returns of the fund, these asset managers charge an annual fee. Expenses may also include the amount paid to analytics, auditors, and marketers that make the mutual fund a success.The expense ratio is the annual fee that a mutual fund takes from the investors for the services it provides. These are the operating expenses of the mutual fund represented as a percentage of the total assets. Typically, smaller mutual funds tend to have higher expense ratios since they will have to recover their expenses from a smaller asset base. At the same time, larger mutual funds tend to have slightly lower expense ratios since they have more assets to set off the expenses against. SEBI’s mutual fund regulations permit charging these operating expenses that are directly or indirectly used in the management of the mutual fund scheme. These may include sales and marketing expenses, advertising expenses, transaction-related expenses, administrative costs, investment management fees, fees paid to the registrar, and audit fees. A sum of these expenses and any other similar expenses are divided by the net assets of the fund to give the Total Expense Ratio (TER).Since it is the representation of a cost, a higher expense ratio signifies lower profits, and a lower expense ratio signifies higher profits. The expense ratio also factors in the duration and maturity of a mutual fund. This could be an indicator for investors to analyze the health of the mutual fund that they wish to invest in. Furthermore, the expense ratio is required to be updated and disclosed every day. Also Read : What Is Security Transaction Tax In Mutual Funds?

As per SEBI regulations, there is a specified limit within which the expense ratio has to be. However, there is no limit to which type of expense is allowed to be counted as an expense for the purpose of calculating the Total Expense Ratio . Regulation 52 of the SEBI regulations around mutual funds is what governs the limits that any mutual fund’s Total Expense Ratio is not permitted to cross. These are revised from time to time.From April 1, 2020, the total permissible limits of the Total Expense Ratio are as follows.

There are no limitations on the nature of expenses that can be included as part of the expense ratio. The following are the typical components of an Expense Ratio.

1. Maintenance Expenses: This refers to the cost incurred to facilitate seamless operations and administrative duties as part of the daily responsibilities of the fund. Maintenance fees could go towards managing proper records, ensuring accurate entry and exit fees of portfolio assets, handling customer support and other such essential services.
2. Management Fee: This refers to the cost incurred specifically and directly for the fund managers and portfolio managers contributing towards the mutual funds. This involves market research and analytics to get accurate results.
   Typically, around 0.5% to 1% of the expense ratio is allocated towards management fees alone.
3. 12B-1 Fee: This refers to the cost of advertising and promotions to spread the information about the mutual fund. The expense incurred to onboard a new investor is also included in this fee.
4. Entry Load: This refers to the amount that an investor pays to the mutual fund at the time of joining. It has an impact on the returns that the investor makes. This entry load could be different for different mutual funds, but the entry load is not allowed to be included in the calculation of the total expense ratio.
5. Brokerage Fee: Typically, there are two categories of mutual funds which are and regular mutual funds. Regular mutual fund plans are when the asset management company employs a broker to process the transactions related to the mutual fund. Direct mutual funds process the transactions themselves. Therefore, brokerage fees in the case of regular funds are a component of the expense ratio.
6. Exit Load: Just like an entry load, exit load refers to the amount payable by the investor when they withdraw funds from the mutual funds. This is calculated on the total amount of investment and is typically around 2% to 3% to dissuade people from withdrawing funds.

Also Read: Fixed deposits vs mutual funds

Expense Ratios represent the expenses that will be reduced from the total revenue of the mutual fund. Therefore, the amount distributed to the investors will be determined after reducing these expenses. Hence, a higher expense ratio is a sign of lower returns, and a lower expense ratio gives higher returns. For example, if an investor makes an investment of Rs. 1,00,000 in two mutual funds but the expense ratios are 2% and 1%, respectively, the actual returns that the investor gets will be reduced by Rs. 2,000 (2% of Rs. 1,00,000) and Rs. 1,000 (1% of Rs. 1,00,000) which is a Rs. 1,000 difference just for 1% higher expense ratio. Therefore, expense ratios are an important factor to consider before making investments in mutual funds. Also Read: Direct Vs Regular Mutual Fund Whis is Better Investment Option Expense ratios are an annual charge. Therefore, if the investment is made for less than one year or more than one year, the expenses deducted from the returns will be calculated proportionately. It is also calculated on the current value of the amount invested on a daily basis. For instance, if the amount invested is Rs. 1,00,000 on 02 April and the expense ratio is 1%, the expense payable on that day will be Rs. 2.74 (Rs. 1,00,000*1%/365). Now, if the amount invested increases to Rs. 1,00,700 on 15 October, the expense payable will be Rs. 2.93 (Rs. 1,07,000*1%/365) for that day. Now, if the value becomes Rs. 99,000 on 21 December, the expense payable will be Rs. 2.71 (Rs. 99,000*1%/365) for that day. Therefore, profit or loss from the mutual funds doesn’t matter. The investor will still have to incur the expense.

Often investors believe that expense ratios for actively managed mutual funds are higher because more work is being put into ensuring maximized returns from the fund. However, this may not be entirely true, as a higher expense ratio alone is not indicative of a well-managed fund. Mutual funds with low expense ratios could also have trained managers with tools to make accurate predictions that yield good returns. On the flip side, an aggressively managed fund may also yield higher returns that compensate for the higher expenses. Therefore, investors must look at the functionality, past performance, expense ratio and expected returns before choosing to invest in a mutual fund. Also Read: Direct Vs Regular Mutual Fund Whis is Better Investment Option