What is an Expense Ratio?
As per SEBI regulations, mutual funds are permitted to charge certain operating expenses for managing a fund. In order to manage a fund, in-depth knowledge of the market is required. A group of people, being fund managers, analysts, etc. manages the fund in order to generate better returns for the investors. These guys track the markets and the companies in the fund’s portfolio.
The expense ratio or annual fund operating expenses is a ratio that measures the per-unit cost of managing a fund. Simply put, it is a ratio of the fund’s total expenses and it’s an asset under management. Say, an expense ratio of 2% per annum means that each year 2% of the fund’s total assets will be used to cover the operating expenses of the funds.
The expense ratio will be higher in a case where the asset under management of a fund is lower. Alternatively, the expense ratio will be lower in case the fund has a higher asset under management.
Expense Ratio Formula
The expense ratio is calculated by dividing the total expenses incurred by the average value of the portfolio.
Expense Ratio = Total expenses ÷ Average value of the portfolio
Lets’ understand the same with the help of an example :
Suppose there is a fund house that has an asset under management worth Rs. 5 crores. In order to manage the fund, the fund house charges management fee, administrative fee along with some other expenses amounting to Rs. 5 lakhs.
The total expense ratio for this fund would be calculated as below :
Expense ratio = 5 lakhs/5 crores = 1%
To clarify the above further, 1% is basically the amount of the total assets that need to be paid out in order to manage the fund.
Of course, the return earned on the above investments by the fund house has to be more in order for you to not lose any money.
Suppose the fund has earned a return of 15% on the investment and if 1% is the expense ratio, then you would earn a return of 14%.
How Important is the Expense Ratio?
Expense-ratio indicates the per-unit cost of managing the funds which are calculated by dividing the total expenses by the total assets under management.
The higher the ratio, the higher the funds are being incurred in-order to manage the fund. A lower expense ratio indicates that lower resources are being used to manage the same assets.
If there is a higher expense ratio, the take-home return will be lower and vice versa.
What are the components of the expense ratio?
The cost incurred by the fund house is recovered from the investor on a day-to-day basis. This is informed to the investors on a six-monthly basis. The expense ratio has an impact on your take-home return.
The various components of expense ratio are below :
Investments made by the fund are dependent on the decisions taken by the fund managers. Fund managers are professionals and possess decades of experience in the same field.
The management fee is basically compensation for these managers for their expertise. Generally, .5% – 1% is deducted as a management fee of the total asset under management.
These are the costs incurred for managing the fund. This includes customer support, client communication, etc. and is dependent on the total assets of the fund.
12-1B Distribution Fee
A 12-1B fee is an annual marketing or distribution fee on a mutual fund. This is considered as a part of the operational expenses of the fund and is included in the total expense ratio.
How Does the Expense Ratio impact Fund Returns?
The expense ratio indicates how much the fund house charges annually to manage the investment portfolio. Before distribution to the investors, these charges are deducted from the revenue earned by the fund house.
Since this has a direct relation with the return that is earned, it is important to carefully analyze the mutual funds before investing.
Suppose if you have invested Rs. 50,000 in a fund that has an expense ratio of 2%, that means you need to Rs. 1000 to the fund house to manage your investments.
What are the Implications of the Expense Ratio?
Since the expense ratio is a charge against the return earned by you, it is important to analyze the implications of the same carefully.
A higher expense ratio means a lower take-home return for you. It is to be noted here that it has to direct relation with the management of the fund. Simply put, a higher ratio does not necessarily mean that the fund is managed better and hence higher profits are generated. Mutual funds which have lower expense ratio who have trained professionals as a part of their team can yield higher return as well.
In the direct plan of the mutual fund, one buys the funds directly from the mutual fund company. In case of a regular plan, one buys through an advisor and is paid a commission by the mutual fund company. This is then recovered as a part of the expense ratio of the plan. Hence it is important to evaluate the funds carefully.