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 affect your returns. So, let’s understand what the expense ratio means and how it affects your returns.

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What is Expense Ratio?

The expense ratio is a percentage that indicates the annual maintenance fee paid to the AMC for managing your investment. In other words, it is the per unit expense to manage and run the mutual fund and varies from one AMC to another. The expense ratio is not paid separately but is calculated as a certain percentage of the daily value.

One advantage of the per day levy is that you incur the expense ratio only for the time when your funds are invested. However, you need to be aware that it marginally reduces your returns and choosing a fund with a lower expense ratio is advisable to maximize the potential returns.

Expense Ratio Formula

Expense ratio = Total expenses / Average asset under management

Total expenses are the costs incurred by the AMC, which includes expenditure like distribution costs, marketing, audit and legal expenses, and fund manager’s fees

Average AUM is the total value of all the investors’ funds in that particular scheme

Components of Expense Ratio

AMCs release the information of various costs and its breakups for complete transparency. The different components of expense ratio include:

• Maintenance fees

  These are incurred for the administration and operations of the mutual fund schemes. Some of these charges include maintaining accurate investor records, determining entry and exit loads, and customer support.

• Management fees

  Management fees are paid to the people who are responsible for the operation of the mutual fund schemes. The fund and portfolio managers spend their time and energy conducting market research to identify and avail profitable investment opportunities.

• Brokerage

  You can invest in a direct or regular plan. The former is directly processed by the AMCs while the latter hires a broker to process all purchase and sale transactions. Brokerage fees increase the expense ratio of a regular mutual fund scheme.

• 12B-1 fees

  AMCs need to distribute all scheme related information to potential investors to create a larger corpus. The costs incurred for bringing in new investors are calculated as the 12B-1 fees and is the amount spent on the promotion of the mutual fund schemes.

Expense ratio is also impacted by the duration and maturity of the mutual fund schemes. All information related to the expense ratio is available on the AMC website.

How does Expense Ratio impact Fund Returns?

The expense ratio is indicative of the annual percentage charged by the AMC for managing your investments. Even a minor change to the expense ratio can impact on the overall returns. For example, if you invest INR 50,000 in a mutual fund scheme having an expense ratio of 2.5%, the annual fees paid to the AMC for managing your investment amounts to INR 1,250. Because expense ratio is the per unit cost of managing and operating the scheme, a higher ratio means reduced returns and vice versa.

Here is an example to help you understand the impact of expense ratio on the returns.

Assume you invest INR 1 lakh in a scheme with a 1% expense ratio. The investment value increases to INR 1.01 lakh and INR 1.07 lakh on the following two dates. The table below shows the expense ratio calculation:

You incur the expense ratio during the holding period even if your investment value decreases. A part of the corpus is used to pay the daily expense ratio, which reduces your actual return on investment.

Expense Ratio Limits

The Securities and Exchange Board of India (SEBI) provides guidelines on the expense ratio based on the type of mutual fund scheme.

Actively Managed Funds

Passively Managed and Closed Ended Funds

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.