Expense ratio in Mutual Fund: Meaning, components & calculation

'What is the expense ratio in Mutual Funds?' You may have thought about this while reading about the details of various Mutual Funds. The expense ratio is always mentioned in the description of these funds because it is an important factor that is considered while evaluating a Mutual Fund. The ratio impacts the returns that you earn from the fund. 

What is expense ratio?

A Mutual Fund pools money from investors and puts it in assets such as stocks, bonds and other securities. The return earned from these investments is given back to you. Mutual Funds incur several operating and administrative expenses to manage such a large pool of funds. They pay salaries, office expenses, audit fees, brokerage, and so on. These expenses are recovered from you in the form of the expense ratio.

'Expense ratio' is the ratio of a fund's operating expenses to its average net asset value (NAV). This ratio is calculated daily and deducted from the NAV of the Mutual Fund units. The expense ratio varies from one fund to another.

Main components of expense ratio

1. Management fees
Fund managers devote their time and experience to selecting securities and delivering returns. This is the amount paid to Mutual Fund managers for managing money on your behalf. Passive funds have lower expense ratios than actively managed ones because they don't require active portfolio management.

2. Legal/ Audit fees
Mutual funds must adhere to regulatory requirements, incurring expenses for legal checks, audits, and compliance. These costs are factored into the expense ratio, ensuring regulatory adherence and transparency.

3. Marketing/ Distributors fees
Expenses related to marketing, awareness, and distribution contribute to the expense ratio of mutual funds. Direct funds typically have lower intermediary costs compared to regular funds, impacting their cost-effectiveness.

Expense ratio formula

Total Expense Ratio (TER) = Total Expenses / Average AUM

Imagine a hypothetical equity mutual fund with assets worth ₹1,000 cr. If the expenses for managing the fund total ₹15 cr (1.5% of ₹1,000), then each investor will pay 1.5% of their investment annually to the fund house, deducted daily for the duration of their investment in the scheme.

You might be wondering, what is the highest expense ratio a fund can charge? Well, it depends on the category of Mutual Funds and the maximum limits set by the SEBI (Securities Exchange Board of India). Mutual Funds are free to charge you any expense ratio as long as it is lower than the prescribed limits. When deciding which Mutual Fund to invest in, compare the ratio to other Mutual Funds in the same category. However, it should not be the sole criterion for choosing a fund.

However, Mutual Funds can charge 0.3% more if the fund receives the higher of:

(a) At least 30% of its new investment inflows, or

(b) At least 15% of the average assets under management (year to date), from investors from beyond the top 30 cities.

How expense ratio affects your investments

The expense ratio is an important factor to consider when selecting Mutual Funds for investment because it directly impacts your returns.

Let’s say you invest 1 lakh in a fund with a 2% expense ratio; you have to pay 2,000 each year for managing your money. So, if a fund makes 10% and has a 2% expense ratio, you would actually get 8%. However, a high expense ratio doesn't always mean low returns. You should consider other things like performance, how the fund is managed, and its track record when picking a mutual fund.

Conclusion

Now that you understand what the expense ratio in Mutual Funds means, you can use this information to maximise your investment returns. You can consider the expense ratio as one of the important parameters in selecting Mutual Funds to invest in.

Do you wish to invest in Mutual Funds? Make small investments regularly conveniently via a Systematic Investment Plan (SIP) in schemes through Axis Bank’s Internet Banking or mobile banking.

Also Read:What is a Mutual Fund & how do they work?

FAQs

Do all Mutual Funds have expense ratios?
Yes, all Mutual Funds have expense ratios. However, some passively managed funds, like Index Funds and ETFs, can have very low expense ratios. 

Does the NAV include the expense ratio?
No, NAV does not include the expense ratio. The total expense ratio is deducted from the asset value while calculating the NAV.

Is the expense ratio charged every year?
The expense ratio is expressed as a yearly percentage, but it is deducted daily from the fund's net asset value. It is calculated on the basis of the daily NAV of the Mutual Fund units.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.
Mutual Fund investments are subject to market risk, read all scheme related documents carefully. Axis Bank Ltd is acting as an AMFI registered MF Distributor (ARN code: ARN-0019). Purchase of Mutual Funds by Axis Bank’s customer is purely voluntary and not linked to availment of any other facility from the Bank. T&C apply.