# How expense ratio eats into your mutual fund gains

Understanding expense ratios and how they impact your mutual fund investments

We recently received a question from one of our readers (we urge all of you to share your names) asking how mutual fund houses charge expense ratios.

Before we answer that question, let's understand what expense ratio is and how it impacts your mutual fund investments.

What is expense ratio
In simple words, it's an annual fee that fund houses charge their investors. It consists of their annual operating costs, which include management fees, administration fees and even advertising and promotion expenses, among others.

It is important to note that while the expense ratio is an annual fee, it is not charged once every year. Instead, it is subtly deducted daily from the fund's net asset value (NAV) .

Since the expense ratio is an intrinsic expense, which is automatically deducted from the NAV, you don't get any receipt on it.

This fee is charged irrespective of the fund's positive or negative performance.

How expense ratio applies to your investments
Let's see an example. Suppose you invest Rs 50,000 in a flexi-cap fund and the holding period is one year.

As with any other investment, there are certain charges applicable. One of them is the Securities Transaction Tax (STT), a direct tax payable on the purchase or sale of securities.

Let's assume the STT to be 0.005 per cent.

This means the total investment amount going into the flexi-cap fund will not be Rs 50,000 but Rs 49,997.5 (Rs 50,000 - Rs 2.5).

Next, let's say the expense ratio is 1.5 per cent.

If you invest your money for exactly 12 months, you will be charged the 1.5 per cent expense fee.

But if you remain invested for, say, nine months, you will be charged on a pro-rata basis for 273 days instead of 365. In this case, you'd have to cough out an expense ratio of 1.125 per cent.

#### How expense ratio affects your investment

Amount invested Rs 50,000
Securities Transaction Tax (STT) 0.005 per cent = Rs 2.5
Actual amount invested Rs 49,997.5
Fund returns 10 per cent
Expected return Rs 54,997.25
Expense ratio (in %) 1.5 per cent
Expense ratio Rs 824.96
Actual return Rs 54,172.29
Actual return (in %) 8.35 per cent

Essentially, after accounting for the expense ratio, the actual gain from the investment over the course of the year is not 10 per cent but 8.35 per cent.

Things to keep in mind

• While the daily deduction is small, the expense ratio incrementally reduces your returns.
• While choosing a fund with a lower expense ratio may be tempting, it should not be the only factor while selecting a fund.
• Instead, you should also consider the fund's five-, 10-year returns, the experience of the fund manager, and how well the scheme aligns with your risk tolerance and investment goals.

Suggested read: Huge reworking of fund expenses starts?

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