There are lots of misconceptions about expense ratio of a mutual fund. Some investors think it is a one time charge, others think it's like a tax on their returns. It is useful to understand how it works.
The expense ratio is computed from the expenses actually incurred to manage the fund. This includes fund management fees (pays for salaries of fund managers & research teams), administrative costs (sending statements etc), trading costs (for buying and selling shares) and distribution costs (brokerage paid to service providers like us).
Actual expenses only
But, it's very important to note that the fund does not just decide that they will charge a certain percentage as the expense ratio. These are actual costs and added up as incurred. Once totaled up, they are reported as a percentage of the fund's AUM and called expense ratio.
So if the 'average' money invested in a fund (AUM of the fund) for a given month is Rs 1000 Cr, and the expense amount chargeable to the fund for that month is Rs 1.6 Cr, then the expense ratio reported will be 1.6/1000= 0.16% per month or 1.92% annualized.
Only permitted expenses
A mutual fund company cannot just bill any random expense either. The regulator SEBI has specified what expenses can be charged and also has placed an upper limit. Funds are audited to ensure they comply with this.
Not unlimited - capped
SEBI also specifies how much is the maximum expenses that can be charged. These vary by fund type & size. In general, equity funds have expense ratio of ~2.25% and debt funds of 2%
Daily charge - in tiny bites
Also, to ensure a fair treatment to all investors, these expenses are not charged all at once but spread out on a daily basis using the appropriate accounting treatments.
So, in our above example, the fund would charge 1.6 Cr/ 31 days or approx. Rs 5.1 lakh (0.005%) every day.
The amount is deducted from the total corpus of the fund and gets divided over the investment of every individual investor. The NAV that is declared every day is after the expenses for the day have been accounted for.
The expense ratio of the fund is published by the mutual fund company periodically and is also available as part of the fact sheets on our website.
What this means to an individual investor
1. Expenses are charged to the fund and NOT to a specific investment transaction.
2. No investor pays a big charge when they invest. Your entire investment amount goes into the fund.
3. Expenses start getting deducted from your money (as part of the pool) from next day onwards on a daily basis as long as you keep your money invested.
4. These being expenses, they are charged irrespective of the performance of the fund.