There are many factors which investors look at while comparing and investing in different mutual funds schemes. The factors include the fund house, past performance of the scheme, expertise, and experience of the fund manager, etc. One of these factors, also a crucial one, is the fund house’s management cost or the AMC. This management cost is also called the expense ratio. It is merely the percentage of the fee charged by the fund house from investors as the maintenance fee.
What is the expense ratio in mutual funds?
The fund house incurs some expenses in managing their funds. A fund house or an AMC (Asset Management Company) employs fund managers and a management team that tracks the markets and makes investments in different schemes. It also incurs costs relating to commissions, allocation charges, registration and transfer, legal fee, audit fee, custodian, etc. These expenses form part of the expense ratio. The expense ratio is per unit cost of managing the fund. These costs are taken into account while calculating NAV (Net Asset Value) and are recovered through unitholders. Thus, the expense ratio becomes a crucial element when deciding about the mutual fund scheme for investment.
How does the expense ratio impact mutual fund returns?
The expense ratio directly affects the returns earned by the fund house. The expense ratio is the amount that the fund house or the AMC charges from unitholders expressed in percentage terms. So if the expense ratio of a mutual fund scheme is 1.5 percent and an individual invests Rs. 10000, then the investor needs to pay Rs—150 to the fund house for managing the scheme. If the same mutual fund scheme earns a return of 12 percent, then the effective return in the hands of the investor comes to 10.5 percent. In other words, the expense ratio is deducted directly from the returns generated by the fund. So it is clear that the low expense ratio increases the investors’ overall returns and the higher expense ratio decreases the returns in the investors’ hands.
What is the ceiling limit set by SEBI for the Expense ratio?
Capital markets regulator SEBI (Securities Exchange Board of India) has ceiling limits for the expense ratio in mutual fund schemes. They have put in various slabs based on AUM (Assets Under Management) for all open-ended equity-oriented mutual funds.
- If the AUM is under Rs 500 crores, the fund house can charge 2.25 percent.
- If AUM is between 500 – 700 crores, 2 percent can be charged.
- For AUM between 750 and 2000 crores, the charges are capped at 1.75 percent
- The charges can be up to 1.6 percent if the AUM is between 2000-5000 crores and 1.5 percent if the AUM is between 5000-10000 crores.
- There is a 0.5 percent decrease in expense ratio for every increase of Rs. 5,000 crores AUM if it is between 10,000-50,000 crores.
- Finally, the charges cannot be greater than 1.05 percent for AUM more than Rs. 50000 crores.
What are the components of the Expense Ratio?
As discussed earlier, the expense ratio includes a number of incurred costs by the fund house. Here is the list of components that form part of the expense ratio in a mutual fund scheme.
Maintenance/ Administrative Expenses
Expenditure such as maintaining proper investor records, customer support, entry and exit fees of assets, information emails, etc., are included in maintenance expenses. These expenses ensure smooth operations of the fund house.
A fund house hires fund managers, portfolio managers, and other management personnel responsible for researching and investing, and creating a portfolio. This component of the expense ratio is allocated to pay for such professionals.
Brokerage/ Commission Fees
There are two plans in a mutual fund scheme- Direct and Regular. There are no brokerage or commission charges in case of direct plans. But when it comes to regular plans, a fund house employs brokers to sell and purchase their mutual fund schemes. Brokerage or a commission is paid to such brokers or intermediaries for their services. Thus, brokerage fees also form part of the expense ratio but only in regular plans.
Distribution Fees/ 12B-1 Fees
This expense includes the amount that is spent on the promotion or advertisement of a mutual fund scheme.
Investors should note that a mutual fund scheme’s expense ratio is vital when it comes to deciding on investing in one. It is so because it directly affects the net profitability of the fund. Though the expense ratios of most of the AMCs or fund houses vary in a range, some AMCs may charge higher expense ratios for their funds. Investors should be wary of these facts and avoid funds that charge unnecessarily high expense ratios. But do not base your decision just on a fund with a lower expense ratio but check up on information like the past performance, expertise of the fund manager and the reputation of the fund house, etc.
Frequently Asked Questions
What is the Expense Ratio in Mutual Funds?
The expense ratio is the cost of running and managing a fund expressed in percentage terms.
What are the components of the Expense ratio?
The main components forming the part of the total expense ratio are Management Fees, Administrative Costs and Distribution Fees
How does the Expense Ratio impact Fund Returns?
The expense ratio directly affects the profitability of the fund. The investor gets less return if the expense ratio is high and vice versa.
How to find the expense ratio of a mutual fund scheme?
Details of the expense ratio of mutual fund schemes can be obtained on their official website and the fund fact sheet of the respective fund house.
What is a good expense ratio for a mutual fund?
It depends on the fund size, age of the fund, and the performance of the fund. However, any expense ratio below 1.75 percent can be considered a good expense ratio.
Are mutual fund expenses tax-deductible?
No. mutual fund expenses are not tax-deductible.
Which mutual funds have lower expense ratios?
Generally, passively managed funds like Index funds have lower expense ratios as they just track and mirror the performance of the index.