Expense ratio is the percentage of total assets that are spent to run a mutual fund. As returns from bond funds tend to be similar, expenses become an important factor while comparing bond funds.
By Research Desk | Jul 4, 2003
A wise man once said: ''There is no free lunch on Wall Street.'' This holds true for investing in a mutual fund too. Like a doctor who charges you for his service, mutual funds too charge a fee for managing your money. This involves the fund management fee, agent commissions, registrar fees, and selling and promoting expenses. All this falls under a single basket called expense ratio or annual recurring expenses that is disclosed every March and September and is expressed as a percentage of the fund's average weekly net assets.
Expense ratio states how much you pay a fund in percentage term every year to manage your money. For example, if you invest Rs 10,000 in a fund with an expense ratio of 1.5 per cent, then you are paying the fund Rs 150 to manage your money. In other words, if a fund earns 10 per cent and has a 1.5 per cent expense ratio, it would mean an 8.5 per cent return for an investor. Funds' NAVs are reported net of fees and expenses, therefore, it is necessary to know how much the fund is deducting (expense ratio can be found in the half-yearly reports of the AMC or on valueresearchonline.com).
Since this is charged regularly (every year), a high expense ratio over the long-term may eat into your returns massively through power of compounding. For example, Rs 1 lakh over 10 years at the rate of 15 per cent will grow to Rs 4.05 lakh. But if we consider an expense ratio of 1.5 per cent, your actual total returns would be Rs 3.55 lakh, nearly 14 per cent less than what would have been achieved without any expense charge.
Different funds have different expense ratios. But the Securities & Exchange Board of India has stipulated a limit that a fund can charge. Equity funds can charge a maximum of 2.5 per cent, whereas a debt fund can charge 2.25 per cent of the average weekly net assets. The largest component of the expense ratio is management and advisory fees. From management fee an AMC generates profits. Then there are marketing and distribution expenses. All those involved in the operations of a fund like the custodian and auditors also get a share of the pie. Interestingly, brokerage paid by a fund on the purchase and sale of securities is not reflected in the expense ratio. Funds state their buying and selling price after taking the transaction cost into account.
Expense ratio matters especially in case of debt funds. Till last year, when bond funds were giving a whopping 14.5 per cent return, nobody cared about expenses. But that's history now. The days of double-digit returns are over. With an all-round reduction in interest rates, bond funds are expected to give a return of 7-9 per cent this year. Thus, in a low yield universe, every penny will count. And as expenses are deducted from the fund before calculating the NAV, it is likely to be a major differentiating factor among bond funds where returns vary marginally.
In case of actively managed equity funds, the issue of expenses is more complicated. The wide divergence of returns between 'good' and 'bad' funds makes the expense ratio secondary. But here too, if you find two similar funds, the expense ratio can be a good differentiator. Perhaps, more important is the fact that expenses are charged at all times. Whether a fund generates positive or negative returns, expenses are always there.
Recently, funds have launched institutional plans for big-ticket investors, where the expense ratio is relatively lower than normal funds. This is because the cost of servicing is low due to larger investment amount, which means lower expenses. Overall, before venturing into any fund just check out this important number. A lower expense ratio does not necessarily mean that it is a better-managed fund. A good fund is one that delivers good return with minimal expenses.