Mutual funds charge you a fee called an expense ratio. Here is how you should interpret it.
24-May-2022 •Ravi Banagere
As it goes for any service that you take, for instance, a lawyer for your legal matters, a chartered accountant for filing your income tax returns, or an architect for your house, mutual fund managers charge a fee for building and managing your investment portfolio. This fee is called the 'expense ratio' of the fund.
The expense ratio is a single basket that includes all the charges that investors need to pay mutual funds companies to manage their money. These include fund management fees, agent commissions, selling and promotional expenses and other charges incurred by the fund.
Calculation of expense ratio
The expense ratio is expressed as an annualised percentage of the fund's assets under management (AUM). Thus, as an investor, you pay a fee in proportion to your investment value in the fund. However, you don't have to pay it separately as it gets adjusted from the returns generated by the mutual fund itself. Sounds a bit complex? Don't worry. Here is an example.
Let's say, you invested in a fund today with an expense ratio of 2 per cent. After a year, the fund earns 15 per cent returns from its portfolio. Now, as an investor, your returns at the end of the year would be 13 per cent, i.e.,15 per cent returns generated by the fund reduced by 2 per cent of the expense ratio. Fund's daily NAVs (net asset values) are reported net of such fees and expenses. Different funds have different expense ratios but SEBI has stipulated an upper limit of 2.25 per cent and 2 per cent on these ratios for equity and debt funds respectively. This fee is charged irrespective of the fund's performance, be it positive or negative.
How to find out the expense ratio of a fund?
To find out the expense ratio of a fund, you can check its disclosures on the website of the given asset management company (AMC). Or you can easily access the same on the respective fund's page on the Value Research website by using the search bar at the top.
How much expense ratio is acceptable?
A high expense ratio over the long-term may significantly eat into your returns. For example, the value of Rs 1 lakh after 10 years with 15 per cent rate of return will be about Rs 4 lakh. But if we include the cost of, let's say 1.5 per cent, expense ratio, your returns would reduce to Rs 3.5 lakh, nearly 13 per cent less than what it would have been without any expenses. So, it's better for investors to choose a fund that has a low expense ratio.
Further, if you are capable of managing your own investments, you may significantly lower your expense ratio and receive higher returns over time by staying away from regular plans. Regular plans have a higher expense ratio as compared to direct plans. This is due to the additional cost of paying commissions to the distributors in the former case. Though the difference between the expense ratio of direct and regular plans might not look substantial in percentage terms, the impact on the overall corpus becomes meaningful over a period of time.
Thus, before venturing into any fund, you should check its expense ratio. But bear in mind that a lower expense ratio does not necessarily make the fund better. A fund that delivers good returns with minimal expenses is the way to go.