Its a zero-sum game, the higher the expense ratio, lower will be your Mutual Fund returns. The expense ratio of a mutual fund is the annual fee that the fund house charges for managing your money.
A lower yearly expense will boost your returns and help you to accumulate a more substantial corpus in the long term. However, the annual fee is not the only factor to consider while choosing a fund.
Here we will examine what the expense ratio is, its components, and its impact on investor returns. We will also discuss the SEBI limits and compare the expense ratios of a few mutual funds.
What is the expense ratio of a mutual fund?
The expense ratio or yearly operating expense of a fund is the percentage of the assets paid to the fund house. The fund manager works with a team of analysts and other specialists to manage and promote the mutual fund. The fund management team strives to maximize returns and cut risk. The expense ratio includes auditor and adviser fees.
A fund with more Assets under Management (AUM) will have a lower expense ratio than one with a smaller asset base.
Also Read: Portfolio Turnover Ratio in Mutual Fund Investing
What does the expense ratio of a mutual fund include?
The expense ratio of a mutual fund includes the various expenses related to managing a fund scheme. The fund house recovers these expenses from the mutual fund investors and reports them to investors once in every six months. These expenses can have a significant impact on your long-term returns.
let us take a closer look at the three main types of costs that constitute the expense ratio:
Administrative expenses
These are the costs of running a mutual fund. Administrative costs include customer service, support, communications, and record keeping.
Management fee
A qualified and experienced fund manager makes investment plans and strategies. The fund manager works with a team of analysts and gets a management fee or an investment advisory fee.
Distribution fee
Several mutual funds collect this fee for promotion and advertising. Typically, the fund charges its shareholders for promoting and marketing the fund to investors.
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What effect does the expense ratio have on a fund’s returns?
The fund house declares the expense ratio as a percentage of the assets. For example, if you invest Rs. 100,000 in a mutual fund, which has an expense ratio of 2%, you will have to pay Rs. 2,000 per year to the fund house for managing your money.
If your mutual fund earns a return of 14% in a year and has a TER of 2%, you will receive a profit of 12%. The fund house reports the Net Asset Value (NAV) after deducting all applicable fees and expenses. That’s why it is essential to know the expense ratio of a mutual fund before investing in it.
Actively-managed funds vs. passively-managed funds
A mutual fund with a lower expense ratio provides higher returns, and a high-cost fund offers a smaller profit. A lower expense ratio is even more critical while investing in mutual funds with low yields.
Actively-managed mutual funds have higher expense ratios than passively-managed funds. You need to see if the alpha generated by the fund manager justifies the higher expense ratio.
If you find that a passively-managed fund is providing similar returns at a lower cost, you can consider switching your money to it.
SEBI’s expense ratio limits
In September 2018, SEBI capped the maximum Total Expense Ratio (TER) for mutual funds of different sizes. SEBI also announced new rules that improved transparency and reduced mis-selling and churning. SEBI specified the maximum TERs for open-ended mutual funds of different sizes:
*Not including ETFs, Index Funds, and Fund of Funds
An example of how the total expense ratio impacts your returns
If you invest Rs. 200,000 in a mutual fund with an expense ratio of 2%, you will have to pay Rs. 4,000 to the fund house every year for managing your money. If the fund provides a return of 15% in a year, you will get a gain of 12% after deducting expenses and fees.
The expense ratio adds up in the long term, impacting the total accumulated corpus. That’s why it’s essential to track the expense ratios of all your mutual funds.
Also Read: Categorization & Rationalization of Mutual Fund Schemes by SEBI
Direct plans vs. regular plans
You can invest either in the regular plan or in the direct plan of a mutual fund. While regular plans pay commission to brokers or distributors, direct plans don’t pay any commission. Returns from direct plans are around 0.5% to 1% higher than returns from regular plans.
If you invest in the direct plan of a mutual fund, you will not have to pay any commission. You will earn higher annual returns, and the difference will add up in the long term.
Comparison of the expense ratios of some mutual funds
* As on Jun 30, 2019
Conclusion
it is essential to consider the expense ratio of a mutual fund because it impacts how much you will accumulate in the long term. However, a low expense ratio isn’t the only thing to consider. You also need to consider your goals, profile, and fund performance, among other qualitative and quantitative parameters. Remember, a mutual fund with a higher expense ratio could provide much better net returns than a low-cost fund.
