What is an Expense Ratio? Learn How to Calculate and Affects of High or Low Expense Ratio

Are you curious about how to invest your money? One of the things that you should consider when investing in mutual funds or exchange-traded funds (ETFs) is the expense ratio. The TER is a fee that fund companies charge to manage their funds, and it can impact your investment returns.

In this blog, we’ll explain what the expense ratio is, why it’s important, and how it can affect your investment returns. So, let’s dive into the world of expense ratios and see how it can affect your investments! Let’s begin by learning what is an expense ratio.

What is Expense Ratio in Mutual Funds? 

Expense ratio in mutual funds is a term used in finance that refers to the percentage of a mutual fund’s assets that are used to cover the fund’s operating expenses. It includes fees such as management fees, administrative fees, and other costs incurred in running the fund. The TER in mutual funds is a useful metric to compare the costs of different funds. 

Understanding the expense ratio is important because it can affect the returns you receive on your investment. A high TER can eat into your returns, making it harder to achieve your financial goals. For example, if you invest Rs. 1,000 in a mutual fund with an expense ratio of 2%, you will pay ₹20 in fees annually, regardless of how well the fund performs. This can add up over time and significantly reduce your returns. Let us now explore the formula for expense ratio and how is expense ratio calculated.

How to Calculate Expense Ratio?

The expense ratio is the annual fee charged by mutual funds or exchange-traded funds (ETFs) to cover their operating expense ratios. It is calculated by dividing the total operating expenses of the fund by the average net assets of the fund over a particular period of time, usually a year. The TER formula has been demonstrated below:

Expenses Ratio Formula for Calculation

Expense Ratio = (Total Fund Costs / Average Net Assets)

Now that we know how expense ratio is calculated, let’s see how TERs work.

How Does Expense Ratio Work?

The mutual fund expense ratio, denoting the cost of owning a mutual fund or ETF, is essentially a management fee paid to the fund company for the privilege of holding the fund. It is expressed as a percentage of your investment. For instance, if a fund charges 0.30 percent, you’ll incur an annual fee of ₹30 for a ₹10,000 investment.

This fee is applied annually as long as you possess the fund throughout the year. It’s crucial to note that attempting to sell the fund just before a year lapses doesn’t exempt you from this cost. In the case of an ETF, the management company discreetly deducts the cost from the fund’s net asset value on a daily basis, making it virtually imperceptible to you.

What are the Components that Make Up the Expense Ratio? 

• Management Fees: These are fees charged by the fund manager for managing the portfolio.
• Administrative Expenses: These include expenses such as legal fees, custodial fees, and accounting fees.
• Marketing and Distribution Expenses: These include expenses incurred in marketing and distributing the fund.
• Other Expenses: These include expenses such as audit fees, taxes, and other miscellaneous expenses.

The operating expense ratios include various costs such as management fees, administrative expenses, legal and audit fees, marketing and distribution expenses, and other costs associated with managing and operating the fund. The total operating expenses are then expressed as a percentage of the average net assets of the fund to arrive at the TER.

For example, if a mutual fund has total operating expenses of ₹1 crore and average net assets of ₹100 crore, the expense ratio would be 1%. This means that the fund charges 1% of the average net assets as an annual fee to cover its operating expenses.

Why Does the Expense Ratio Matter?

The expense ratio is an important factor to consider when investing in mutual funds or ETF as it directly impacts your investment returns. 

A high TER means that a significant portion of your investment returns goes towards paying fees, which can reduce your overall investment returns. 

For example, if you invest ₹10,000 in a fund with a 2% expense ratio, you would pay ₹200 in fees annually. However, if you invest the same amount in a fund with a 0.5% expense ratio, you would only pay ₹50 in fees annually.

Therefore, it’s important to consider the TER when selecting mutual funds or ETFs, as it can significantly impact your investment returns over the long term. By choosing funds with lower expense ratios, you can potentially increase your investment returns and achieve your financial goals faster.

What is the Total Expense Ratio?

Under SEBI (Mutual Funds) Regulations, 1996, Mutual Funds can charge operating expenses for managing a scheme, including sales, marketing, administrative, transaction, investment management, registrar, custodian, and audit fees. These costs collectively form the ‘Total Expense Ratio’ (TER), calculated as a percentage of the scheme’s average Net Asset Value (NAV).

As of April 1, 2020, the TER limits for Mutual Fund AMC are specified under Regulation 52 of SEBI Mutual Fund Regulations. The revised limits are based on the Assets Under Management (AUM):

• On the first Rs. 500 crores: Equity funds – 2.25%, Debt funds – 2.00%
• On the next Rs. 250 crores: Equity funds – 2.00%, Debt funds – 1.75%
• On the next Rs. 1,250 crores: Equity funds – 1.75%, Debt funds – 1.50%
• On the next Rs. 3,000 crores: Equity funds – 1.60%, Debt funds – 1.35%
• On the next Rs. 5,000 crores: Equity funds – 1.50%, Debt funds – 1.25%
• On the next Rs. 40,000 crores: TER reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets or part thereof.
• Above Rs. 50,000 crores: Equity funds – 1.05%, Debt funds – 0.80%

Furthermore, mutual funds are free to charge an additional 30 basis points for new inflows from retail investors in tier-2 and tier-3 cities, encouraging broader participation.

TER significantly influences a scheme’s NAV; a lower TER correlates with a higher NAV. Therefore, TER is a crucial factor when selecting a mutual fund scheme. As per current SEBI Regulations, mutual funds must disclose the TER of all schemes daily on their websites and AMFI’s website.

What are the Types of Funds with Expense Ratios? 

There are different types of funds that you can choose from, each with its own TER. Here are a few types of funds with expense ratios:

• Mutual Funds: Mutual funds are a type of investment fund that pools money from multiple investors to purchase securities. Mutual funds typically charge a management fee, which is part of the TER. The expense ratio for mutual funds can range from less than 0.10% for low TER mutual funds to over 2% for some actively managed funds.

• Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds, but they are traded on an exchange like a stock. ETF TER is typically lower than the TER for mutual funds. The ETF expense ratio can range from less than 0.10% for some index ETFs to over 1% for some actively managed ETFs.

• Index Funds: Index funds are a type of mutual fund or ETF that tracks a specific index, such as the S&P 500. Index fund expense ratio is lower as compared to actively managed funds because they require less management. The index fund expense ratio can range from less than 0.05% for some low-cost index funds to over 1% for some specialty index funds.

How to Evaluate Total Expense Ratios? 

Evaluating expense ratios can help you to make informed decisions about your investments. Here are a few ways to evaluate expense ratios:

• Industry Benchmarks: For example, the average Index fund expense ratio is generally lower than that of actively managed funds. Nifty BeES expense ratio is an index fund that tracks the Nifty 50 index and has a low TER of around 0.10%.

• Comparing Expense Ratios Across Similar Investments: You should compare the expense ratios of similar investments to determine if they are paying more than necessary. 

• Considering the Fund’s Investment Strategy: Investors should also consider the fund’s investment strategy when evaluating the TER. For example, actively managed funds typically have higher expense ratios due to their strong history. 

How to Choose Funds with Low Expense Ratio?

High expense ratios for mutual funds can significantly impact your financial outcomes. To identify funds with lower expense ratios, consider the following:

• Most Exchange-Traded Funds (ETFs) are passively managed index funds, designed to mirror a specific index, making them cost-effective compared to the average mutual fund.
• Index mutual funds, also passively managed, generally have even lower costs than ETFs, but they come with certain drawbacks relative to ETFs.
• Funds tied to major indices like the S&P 500 typically have the lowest expense ratios.
• A recommended starting point is S&P 500 index funds, available as either ETFs or mutual funds. ETFs are usually the preferable choice.

For those willing to put in some effort, leading brokers in ETF investing provide screeners. These tools enable you to sift through the fund landscape, identifying high-performing, low-cost options. Simply specify your criteria, and the screener will highlight the top picks.

What is a Good Expense Ratio for a Mutual Fund?

The ideal Total Expense Ratio (TER) differs based on the investment strategy and fund type, making it challenging to pinpoint a universally “good” TER. Generally, a lower expense ratio is preferable, as it can help you to maximize returns. However, the TER should be evaluated in the context of the fund’s investment strategy, as a higher TER may be justified if the fund has a history of delivering higher returns. 

Therefore, it is also important to consider the TER, which includes other costs associated with investing. In general, you should aim for a TER that is as low as possible while still aligning with your investment goals and strategy.

Impact of Expense Ratio on Fund Returns

Expense ratios play a crucial role in determining the actual returns investors receive from a mutual fund. These ratios represent the percentage of total revenue deducted by the fund before distributing profits to investors. A higher expense ratio means a larger portion of returns is taken away, resulting in lower returns on investments.

Investors must scrutinize expense ratios when selecting a mutual fund, as they directly affect annual returns. Contrary to a common misconception, a higher expense ratio doesn’t necessarily indicate better fund management or increased profit potential. A mutual fund with a lower expense ratio, coupled with skilled management and accurate market predictions, can yield substantial returns.

High expense ratios in mutual funds can signal aggressive management aiming for higher yields or investments in companies with a greater likelihood of profit. The generated revenue, in such cases, compensates for the elevated expenses incurred.

Limitations on Expense Ratio Issued by SEBI

To safeguard investor interests, the Securities and Exchange Board of India (SEBI) imposes restrictions on expense ratios charged by asset management companies. Different rules apply to Exchange Traded Funds and Index Funds. For instance, the maximum TER for an initial asset base of Rs. 500 Crore is 2%, with subsequent tiers incurring lower ratios.

Under Section 52 of SEBI Mutual Fund Regulations, asset management companies can charge a maximum total expense ratio of 2.5% for the first Rs. 100 Crore of the portfolio value, with decreasing rates for subsequent asset values. These regulations aim to ensure a significant flow of financial resources into the country’s capital market, providing investors with a transparent and regulated investment environment.

What are the Strategies to Minimize Expense Ratios? 

• Low-Cost Funds: Minimize expense ratios by investing in low-cost funds that have lower management keeping fees and operating costs. 

• Passive Index Funds: By investing in passive index funds (such as the S&P 500), you can minimize their expense ratios and potentially achieve higher returns over the long term.

• Diversifying Across Asset Classes: You can minimize expense ratios by diversifying across different asset classes, such as stocks, bonds, and real estate. 

Expense Ratio Example 

Let’s assume that XYZ Asset Management Company manages a mutual fund that invests in a diversified portfolio of stocks. The TER ETF or of the fund is 1.5%, which means that the company charges 1.5% of the total assets under management as fees for managing the fund.

For instance, if you invest ₹10,000 in this fund, the annual fee charged by the company would be ₹150 (i.e.1.5% of ₹10,000). This fee covers the cost of managing the fund, including research, trading, and administrative expenses.

Expense Ratio Vs Management Fees

Here is a comparative analysis of management fees and expense ratio:

Aspects of Differences	Management Fees	Expense Ratio
Purpose	Cover operating costs, including hiring investment advisors.	Represents the total cost of running the fund, including management and operational expenses.
Operating Fees Beyond Investments	Focus on hiring and retaining advisors, excluding trading costs.	Encompass various operational expenses: marketing, legal, auditing, customer service, office supplies, filing, and administrative costs.
Expense Components	Encompass all direct expenses related to managing investments.	Combination of management fees and other operational costs.
Transaction Costs Distinction	Excludes buying/selling security costs; separate from fees.	Transaction costs, not part of management fees, detailed in the prospectus as the trading expense ratio.
Calculation Basis	Directly linked to managing investments and advisor compensation.	Reflects the total cost of fund operation, including both managing investments and various operational expenses.

Expense Ratio Limit by SEBI

Asset management companies must adhere to Securities and Exchange Board of India (SEBI) restrictions when determining expense ratios for their mutual funds. This safeguard is in place to protect investor interests and maintain a significant flow of financial resources to the country’s capital market.

Distinct regulations apply to Exchange Traded Funds and Index Funds. Funds with an initial asset base of Rs. 500 Crore carry a maximum total expense ratio of 2%. The next Rs. 250 Crore incurs a ratio of 1.75%, and any amount beyond that is subject to a 1.5% ratio.

According to Section 52 of the SEBI Mutual Fund Regulations, asset management companies can charge a maximum total expense ratio of 2.5% for the first Rs. 100 Crore of the portfolio value. For subsequent asset values up to Rs. 300 Crore, a maximum rate of 2.25% applies, with a 2% charge for further slabs related to the remaining asset value.

To Wrap It Up…. 

To conclude, mutual fund and ETF returns are reduced by expense ratios to help cover operating and fund management costs. Expense ratios vary depending on investment strategy and trading activity of a fund. 

Therefore, understanding the expense ratio is crucial for you, if you’re looking to make informed investment decisions. By choosing low-cost funds, you can minimize fees and potentially increase their investment returns over the long term.

FAQs

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