When investing in a mutual fund scheme, you judge the risk profile, the asset portfolio and the returns of the scheme before investing in it. You even compare the scheme’s returns with other schemes in its category to choose the best. While everything is given consideration, do you judge the expense ratio of the fund as a parameter when comparing?
Many of you don’t because you don’t understand the concept of expense ratio and how it affects your mutual fund investments. You, however, should as the ratio directly affects your returns. So, let’s understand what the expense ratio means and how it affects your returns.
What is an expense ratio?
In simple terms, expense ratio of a fund is the fees which the mutual fund house charges for managing your investments. The fund house incurs various expenses in collecting your investments, channelling them into various investment avenues, generating returns, and managing the funds invested. These expenses are recovered from you, the investor in the form of expense ratio. The ratio is calculated as below –
Total expense ratio (TER) = (total expenses incurred by the fund / total assets under management)
The ratio, therefore, represents per unit cost of managing the scheme.
Which expenses are included in the calculation of TER?
The common expenses included in calculation of the TER are as under–
- Fund management expenses which represent the fee payable to the fund managers to manage the fund
- Fee payable to the registrar, transfer agent, custodian, etc.
- Legal and audit fee
- Commission payable to mutual fund brokers (the commission is not applicable in direct plans of mutual funds which are bought directly to the fund house without involving middlemen)
- Marketing and distribution expenses incurred in promoting the fund
How is the expense ratio applied?
The expense ratio is calculated and collected from the investors on a daily basis. The mutual fund house fixes the daily Net Asset Value (NAV) of the scheme after deducting the per day expense ratio.
Changes in the TER
You often get a notice from your mutual fund house stating a change in the TER. If the fund’s expenses change and/or the assets under management change the TER would also change. The fund house is mandated by SEBI to disclose any change in the TER and communicate the same to the investor. That is why you get regular updates about the changes in the TER of the scheme.
Limits on the TER
SEBI has revised the maximum limits to be charged as the TER for all mutual fund schemes. The limit depends on the type of fund and assets under management and is fixed in different brackets. The limits are as follows –
For open-ended schemes
Close-ended & interval schemes
The TER of equity oriented scheme(s) shall not exceed 1.25 per cent of the daily net assets of the scheme &for other schemes TER shall not exceed 1.00 per cent of the daily net assets of the scheme.
Fund of fund schemes
FoFs investing in liquid schemes, index fund schemes and exchange traded funds -TER of the scheme including weighted average of the total expense ratio levied by the underlying scheme(s) shall not exceed 1% of the daily net assets of the scheme.
FoFs which invest in equity oriented schemes, TER of the scheme including weighted average of the total expense ratio levied by the underlying scheme(s) shall not exceed 2.25% and for other than equity oriented schemes same shall not exceed 2.00%of the daily net assets of the scheme.
In case of an Index fund scheme or Exchange traded fund, the TER of the scheme including the investment and advisory fees shall not exceed 1.00 per cent of the daily net assets
How does the expense ratio impact your returns?
The final thing which you should know about expense ratio is how the ratio affects your returns. The concept is quite simple. A higher expense ratio means lower returns and vice-versa. This is because as the expense ratio increases, your returns are reduced as the NAV reduces. For instance, if the TER is 2% and your fund gives you a return of 20%, you would be getting an effective return of 18% only. If the TER reduces, the returns increase. Even minor changes in the TER have effects on long-term returns because of the effect of compounding.
So, while choosing a mutual fund scheme, you should also check mutual fund schemes expense ratio along with other parameters as it can impact on your long-term returns.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.