You have found the perfect Mutual Fund to invest in. But have you checked its Expense Ratio? This is one parameter that will help you judge whether the fund is being managed well. Also, a higher ratio will mean you will possibly be getting lower returns from the fund. Read on to find out what this is all about.
Additional Reading: Understanding Mutual Funds
What Is An Expense Ratio?
An Expense Ratio measures the cost of managing a fund and is expressed on a per unit basis. The formula goes like this: the fund’s total expenses divided by the amount of assets that it is managing.
Now, what are the expenses that a fund might incur? Mutual Fund houses employ professionals for running the fund. This is, of course, a specialised service for which the fund house pays a management fee. Then there are expenses for operating a fund. These include transfer fees and fees for registrar agents. These are entities that help in issuing Mutual Fund units and redeeming them. They also provide other Mutual Fund services such as preparing transfer documents and maintaining investor records. Other expenses include custodian charges, legal expenses, and auditing expenses. We are not done yet! Then there are marketing charges and distribution expenses. Managing a Fund is an expensive affair, indeed! Note that the amount of money that a fund spends for trading in the securities (buying and selling of stocks and bonds) is not included in the Expense Ratio.
So, through the Expense Ratio, the fund is trying to recover these costs from you, the Mutual Fund unit holder. The Expense Ratio is calculated by the fund house and is published in fund house reports twice a year.
How does it affect you?
Let’s take an example. Suppose you are investing Rs. 2 lakh in a Mutual Fund which has an NAV of Rs. 10. Let’s say the Expense Ratio is 2%. Now, you have got a return of 10% from the Fund after being invested in it for a year. So, the value of your investment would have gone up from Rs. 2 lakh to Rs. 2.2 lakh. But, if after the Expense Ratio has been deducted, your investment value will be only Rs. 2.16 lakh, that’s a loss for you.
Is there a limit?
The Securities Exchange Board of India (SEBI) has put in ceiling limits for Expense Ratios. If it is an equity fund, the fund house is allowed to have a maximum of 2.5% as the Expense Ratio. The figure is 2.25% if it is a debt fund. Wait! There are also slabs for these Expense Ratios. For the first Rs. 100 crore of the average assets, the Expense Ratio can be 2.5%. This will go down to 2.25% for the next Rs. 300 crore. And for the assets that go beyond that amount, the Expense Ratio can be only 1.75%. Note that in case the Mutual Fund is receiving funds from the top 15 cities in the country, it is allowed to charge an additional Expense Ratio of 30 basis points. SEBI has come up with proposals to lower the Expense Ratio further and rulings are expected on this front soon. Even though the limit is set, some funds will typically have a low Expense Ratio because of their nature. This includes index funds. These are funds that mimic an index and there is no strategy needed for managing these funds. So, the expenses for these funds are low.
Whether an Expense Ratio is good or bad will depend on the type of fund you choose. For equity funds, the Expense Ratio might not have as much of an impact as for a debt fund. This is because equity funds usually give double digit returns. For debt funds, Expense Ratio is crucial. Consider this: a debt fund is giving you a return of 9% per annum. If the Expense Ratio for the fund is 2%, your actual returns will be just 7%, which is not great. That is why you need to look for funds with a low Expense Ratio – ideally, between 1% and 2%.
An Expense Ratio is a perfect example of how costs can reduce your returns. Here’s another tip on how to save on costs involved in Mutual Fund investments – Invest in Mutual Funds directly through the fund house. This way you can cut the agent commission and save on those costs. Lower costs = higher returns!