Mutual Funds Expense Ratio

Mutual Funds Expense Ratio

If you are one among those who are looking to invest in mutual funds, it is very likely that you have done your bit of research about how the mutual fund market works. While doing so, you must have stumbled on the term ‘expense ratio’ or heard about the same from a fund manager who may be handling your investment portfolio. What does this term mean and how do they affect your returns? Let us understand all about the expense ratio of a mutual fund below.

Defining Expense Ratio of Mutual Fund:

Expense ratio is the fee that mutual funds charge to manage your money, much like a physician who charges a fee for his service. Based on the type of fund, the expense ratio may vary and simply put, it is the expense involved in operating a mutual fund. The highest chunk of the operating expenses goes towards the fee of the fund manager or advisor while the rest is distributed towards costs of custodial services, legal services, registrar fees, recordkeeping, accounting and auditing fees, etc. Some operating expenses may also include marketing costs.

Since expense ratio is deducted from your investment daily following which the Net Asset Value (NAV) is published, you do not feel the pinch but if you are considering long-term gains (for a period of more than 5 years), it can make a lot of difference in your investment returns.

As per the regulations issued by the Securities and Exchange Board of India (SEBI), the expense ratio of an equity fund cannot exceed 2.5% while for a debt fund, the maximum limit is 2.25%.

How is the Expense Ratio calculated?

The expense ratio is expressed as a percentage of the average weekly net assets of the fund and is calculated as follows:

Expense Ratio = Operating Expenses/Average Value of Fund Assets

In the above calculation, loads and sales commissions are excluded since these charges are one-time costs. Trading-related activities are also excluded while calculating the expense ratio. It is an indication of the efficiency in which a fund is managed. Actively managed funds have higher expense ratios while index funds carry lower expense ratios.

The expense ratio of a mutual fund is disclosed twice in a year, in March and September.

How does Expense Ratio affect your returns?

As stated above, the expense ratio is an indication of the amount that the fund house charges you for handling your investment portfolio and is expressed as an annual percentage. So, if you have made an investment of Rs.10,000 with an expense ratio of 1.5%, you will be paying Rs.150 to the fund house. If the fund grows by 10%, you will only receive 8.5% returns as 1.5% will be deducted as an expense ratio. If you are looking at a short-term investment, this amount may appear trivial but if you are making an investment for a period of say 15 years, this amount will get compounded. You will realise that you could have fetched higher returns if you had made the investment in a fund with a lower expense ratio.

Let us now take an example of how an investment of Rs.1 lakh will perform with different expense ratios over a period of 1, 5, 10, 15, and 20 years.

Years 0% 0.5% 1% 1.5% 2%
1 Rs.1,12,000 Rs.1,11,400 1,10,880 Rs.1,10,320 Rs.1,09,760
5 Rs.1,76,234 Rs.1,71,872 Rs.1,67,597 Rs.1,63,407 Rs.1,59,302
10 Rs.3,10,585 Rs.2,95,400 Rs.2,80,887 Rs.2,67,019 Rs.2,53,770
15 Rs.5,47,357 Rs.5,07,711 Rs.4,70,759 Rs.4,36,329 Rs.4,04,261
20 Rs.9,64,629 Rs.8,72,614 Rs.7,88,977 Rs.7,12,993 Rs.6,43,994

The above calculation is done considering 12% returns.

Please note that high expense ratio does not necessarily always translate to low returns. Even funds with high expense ratio can offer high returns when managed aggressively with proper choice of stocks and investment.

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