What is Expense Ratio in Mutual Funds?

What is Expense Ratio in Mutual Funds

Every service has its service charges. When a professional team works behind a mutual fund to make them perform, it also demands a price tag. This service charge in mutual funds is the Expense ratio.

AMC (Asset Management Companies) will hold numerous mutual fund plans, and the fund manager and the team manage every fund.

So, every fund house spends a lot in managing the fund, researching, regulating RTA for buying, redemption, statement, and many more.

These behind-scenes managements are charged as an expense by a ratio to the fund’s total AUM (Asset Under Management).

In this article, we will slice down the basics of the expense ratio, its formula, how it is a calculator and lessons for investors.

What is the Expense Ratio in Mutual Funds?

An expense ratio is a percentage (annual maintenance charges) you will pay to the fund house to manage your investments. This is also called the total expense ratio (TER).

As per SEBI regulations, 1996, Mutual fund companies are entitled to charge a fee for managing the funds. TER comprises the expenses related to marketing, administrative costs, transaction costs, fund management, audit, custodian, and registrar fees.

A Scheme’s TER is calculated as a percentage of its average Net Asset Value (NAV). Expenses are deducted from the daily NAV of a mutual fund to determine the NAV.

Expense ratios are switchable, meaning that any type of expense is allowed as long as the total expense ratio does not exceed the prescribed threshold.

Regulation 52 of SEBI Mutual Fund Regulations specifies the regulatory limits on TER that can be charged by Mutual Fund AMCs.

The value of TER depends on the size of the fund managed. The mutual funds that consist of smaller pooled investments have a slighter high expense ratio.

Here is the latest TER slab as per SEBI effective April 1st, 2020.

TER Slab for Actively Managed Fund

AUM in Crores Max TER for Equity Schemes Max TER for Debt Schemes
0 – 500 2.25% 2%
500 – 750 2% 1.75%
750 – 2000 1.75% 1.5%
2000 – 5000 1.6% 1.35%
5000 – 10000 1.5% 1.25%
10000 – 50000 Starts at 1.5%, and comes down by 0.05%, as fund increase by 5000 crores Starts at 1.25%, and comes down by 0.05%, as fund increase by 5000 crores
More than 50000 1.05% 0.8%

TER Slab for Passive Fund

Fund Types Max TER
Close-ended Equity Funds 1.25%
Other than Close-ended Equity Funds 1%
Index Funds/ EFT’s 1%
FoF – Index/Liquid/ETF funds 1%

How is Expense Ratio Calculated?

Here is the formula to calculate the expense ratio for any mutual fund in India.

Expense Ratio = Total Expense Managed for the Fund / AUM.

For example, imagine that a fund manages Rs. 1000 crores and spends around 20 crores on management, marketing, and audit. The expense ratio will be 2%.

However, according to SEBI guidelines, every fund house should have a maximum TER limit (refer to the above table).

NAV will be deducted by 2% after trading hours each day. Hence, the NAV shown in fund details is after TER deductions.

What are the Components of the Expense Ratio?

Mutual funds work with multiple frameworks, consisting of professional teams and other liaisons. The group consists of a fund manager and many equity research analysts work on behalf of investors to keep the fund performing.

Other stakeholders include sponsors, RTA, administration, marketing, sales team, etc. All these departments need a monetary to run the show. So, here is the complete detail of components of TER used in AMC (Asset management company).

Management Fees:

These components of the TER are the fund manager and team cost. One of the important teams that work on research, purchase of securities, managing the portfolio, and calculating the market risks, and predictions.

It is the fund manager’s responsibility to ensure that the investment objectives of each mutual fund are achieved. A fund manager’s compensation is included in the management fees of actively managed mutual funds.

Since the fund manager of passively managed funds does not have to manage the portfolio actively, the management fees of the mutual fund are much lower than that of active funds.

Legal or Audit Fees:

The Securities and Exchange Board of India (SEBI) regulates mutual funds in India. So, every scheme should undergo compliance and be subject to regular auditing.

SEBI intervenes in the process of every mutual fund (scheme). The cost related to the auditing process, registration, transfers, and legal procurements. So, these legal fees are a part of TER (Total Expense Ratio).

Marketing Fees(12B-1):

Every scheme is promoted by either AMC or a third party on behalf of the AMC. So, the new funds (NFO) should be promoted to the target audience (public) for maximum registration under the fund.

Promotion and awareness of the fund are not restricted to NFO, it should be promoted to reach a wider audience. So, the marketing charges are inclusive of the expense ratio.

Brokerage or Distribution Fees:

Mutual funds are classified into two types based on distributions—regular and Direct mutual funds.

An equity research expert or a financial planner manages a regular mutual fund. The AMC (Asset Management Company) will pay its brokerage fee.

On the other hand, direct funds are when the investments are made directly to the AMC.

Brokerage fees are included in the TER of any fund, and that’s where the regular funds have a high expense ratio compared to direct funds.

Maintenance Fees

Mutual funds are borne by multiple processes apart from management and distribution. Every fund house has administrative, customer care, regulatory, compliance, and RTA teams.

The charges that help a smooth fund accumulation, management, purchase, and redemption process cover the maintenance fees.

What are the Impacts of Expense Ratio in Mutual Funds?

The expense ratio has a huge impact on the overall performance. Here we will compare a mutual fund scheme with Direct (low TER), and Regular (high TER) plans.

Axis Small Cap Funds – Direct Plan Axis Small Cap Funds – Regular Plan
Expense Ratio 0.46% 1.92%
SIP per month Rs. 15,000 Rs. 15,000
5 Years Performance 19.53% 17.87%
5 Years Investment 9 Lakhs 9 Lakhs
Return Post 5 Years 15.3 Lakhs 14.59 Lakhs

The above table shows the difference between Axis small-cap fund’s regular and direct plans.

The difference in expense ratio between the two plans is 1.46%. Similarly, the difference in performance for 5 years is 1.66% per annum.

You got it right. Yes, the difference between expense ratios is proportionally the same as the difference in 5 year’s performance.

This proves that the expense ratio implies the fund’s performance. The difference between direct and regular funds shows direct funds have higher performance as a whole.

The difference in return for 5 years would be microscale. But, this difference of 1.66% in return every year would reach a difference of a few lakhs when invested for 10+ years.

Key Takeaways:

  • The expense ratio is the cost that every fund house charges an investor for managing the fund.
  • This is calculated by dividing the total expense for a fund by the total AUM.
  • SEBI regulates the maximum TER slabs for any mutual funds schemes to operate.
  • TER (Total expense ratio) consists of various fees like management, maintenance, marketing, distribution, legal, etc.
  • It is always great to invest in the funds that come with low TER.