What is the expense ratio and why is it important for you?
The daily NAV of a mutual fund is disclosed after deducting the expenses; bigger funds ideally have lower expense ratio
Everything in life comes at a cost and we know it well. That’s the reason when we plan to buy a new phone, we first look at the price. Or even while booking a room for the next vacation, the first thing we look at is the rate of the room. Even while buying vegetables we first ask about the price and then buy it. Yet somehow most of us forget to ask about the costs when it comes to mutual funds. Just like any other product or service even mutual funds charge a small fee for managing your money. This fee is charged in the form of an expense ratio. So, let’s first understand what an expense ratio is.
What is Expense Ratio?
Under SEBI (Mutual Funds) Regulations, 1996, Mutual Funds are permitted to charge certain operating expenses for managing a mutual fund scheme. These expenses include sales & marketing/advertising expenses, administrative expenses, transaction costs, investment management fees, registrar fees, custodian fees, audit fees – as a percentage of the fund’s daily net assets. All such costs for running and managing a mutual fund scheme are collectively referred to as ‘Total Expense Ratio’ (TER)
The TER is calculated as a percentage of the Scheme’s average Net Asset Value (NAV). The daily NAV of a mutual fund is disclosed after deducting the expenses.
How is the expense ratio decided & charged?
The value of an expense ratio depends upon the size of the mutual fund in question. If the funds’ assets are small, then the expense ratio can be high. Similarly, if the net assets of the fund are significant, then the expense percentage should ideally come down. However, these expense ratios should be charged based on SEBI’s rules and regulations for the Total Expense Ratio (TER). Effective from April 1, 2020, the TER limit has been revised as follows.
In addition, mutual funds have been allowed to charge up to 30 bps more, if the new inflows from retail investors from beyond top 30 cities (B30) cities are at least (a) 30% of gross new inflows in the scheme or (b) 15% of the average assets under management (year to date) of the scheme, whichever is higher. This is to encourage inflows into mutual funds from tier – 2 and tier – 3 cities.
Why is the expense ratio important to you?
Expense ratios are usually deducted from total revenue generated by a mutual fund, before disbursing it to the investors. Higher expense ratios imply a higher proportion of the returns being removed, thereby providing lower returns on investments.
For instance, let’s say you invest Rs 1 lakh in a fund with an expense ratio of 2%. The average annual return delivered by the fund is 10%. So ideally, due to compounding, by the end of 10 years, your investment value should have been Rs 2,59,374. But it will only be Rs. 2,15,892 because of the 2% expense ratio that eats into your returns bringing it down to 8% rather than 10%.
Since expense ratios levy a burden on annual returns earned, an investor should carefully analyze the same while choosing a mutual fund scheme to invest in.
Just like in other things we look at the cost but take a decision based on many other aspects like quality of the product, its durability. Similarly, in mutual funds, it’s important to look at the expenses ratio but a decision should be also based upon many other things. Remember, a good fund is the one that delivers good performance with optimal expenses.