Mutual Fund Expense Ratio in-depth analysis: Every financial product comes up with the certain inherent cost of investment and so does mutual fund investment too. In the recent past, there has been too much noise in the mutual fund industry regarding the Mutual Fund Expense Ratio.
Needless to say that there are few questions that are moving around every now and then in the investors’ mind like whether Mutual Fund expense ratio does impact investment portfolio, how to calculate Mutual Fund expense ratio and lastly what is a good expense ratio for a mutual fund?
Mutual Fund Expense Ratio or Total Expense Ratio
Mutual Fund Expense Ratio can be described as the fees charged by the Asset Manager or Fund Manager of the AMC for managing your money in a mutual fund scheme. So, in simple terms, the mutual fund expense ratio is the cost (Deducted from the NAV) of buying a mutual fund scheme expressed in percentage(%) terms annually.
Though this expense ratio is expressed annually but it is calculated on a daily basis and the Net Asset Value or NAV is calculated after deducting such expense ratio on a daily basis.
Thus in the finance parlance, it can be said that the Mutual Fund Expense Ratio is nothing but the operating expenses(day to day expense) for managing investors money in an actively or passively managed equity or debt mutual fund scheme. This ratio is also known as the Total Expense Ratio.
Now let’s see what components come under the purview of mutual fund expense ratio or Total expense ratio. Basically, the mutual fund expense ratio can be classified into two categories such as A. Initial Issue Expenses and B. Recurring Expenses.
A. Initial Issue Expenses under Mutual Fund Expense Ratio
Asset Management Companies have to incur some expenses when a new scheme is launched. This expense helps the fund manager to reap the benefits from this over a long period of time. Therefore, this expense can not be charged to the initial year of issue in full. So, SEBI permits amortization of initial issue expenses over the life of the scheme for Close Ended Scheme and maximum for 5 years for Open-Ended Scheme.
B. Recurring Expenses under Mutual Fund Expense Ratio
The recurring expenses of a mutual fund scheme primarily incorporate the following expenses such as:-
- Distributors’ commission that is meant for marketing & selling expenses;
- Administrative expenses to manage the fund;
- Payment made to registrars for transfer of units sold or redeemed;
- Custodian Charges;
- Audit Fees;
- Various Communications published in media;
- Cost of providing an account statement;
- An insurance premium paid by the fund;
- Cost of statutory advertisements;
- Cost of termination of a scheme if any;
- Other costs as approved by the SEBI from time to time.
Statutory norms of SEBI on Total Expense Ratio
The Initial issues expenses and recurring expenses incurred for managing the equity funds or debt funds of mutual fund schemes whatever it may be form the Total expense ratio of the scheme. However, this Total Expense Ratio is governed by Regulation 52 of the SEBI Mutual Fund Regulation.
As per this regulation, a fund manager can not charge a higher expense ratio as specified in Regulation 52. Thus, the total expense ratio for investment management fees and advisory fees for actively managed equity funds should not exceed the following threshold limits:-
For equity funds:
- For first ₹100 Crores of the average weekly Net Assets – 2.50%
- For next ₹300 Crores of the average weekly Net Assets – 2.25%
- For next ₹300 Crores of the average weekly Net Assets – 2.00%
- For the balance AUM – 1.75%
For debt funds:
This expense ratio is 0.25% lower of the equity fund as shown above.
How Mutual Fund Expense Ratio is charged?
Since SEBI has regulated the maximum permissible limit for the expense ratio that can be charged by the AMC, an investor should know how this is charged in the practical sense. For example, if you have invested ₹1 Lakh in a mutual fund scheme and the expense ratio is 2.5 %, you are supposed to pay a fee or operating cost of ₹2500 annually. However, this not as simple as it looks. Let’s see below in the calculation portion in detail for easy understanding.
- Do you know how to how to calculate Tax on Mutual Funds? Read Here.
- Do you know how to how to evaluate and compare mutual funds return? Read Here.
Mutual Fund Expense Ratio Calculator
In the above example, I said that the AMC would charge you ₹2500 annually for ₹1,00,000 investment amount. But this amount is not being charged upfront. This ₹2500 fees would have to be paid over a period of 365 days. Yes, the expense ratio is expressed in annual terms like 2.5% in this case but it is calculated on a daily basis on the investment value.
Say after investing ₹1,00,000 in a mutual fund scheme, the investment value becomes ₹101000 on day 1. So, on day 1 your cost of investment would be ( ₹101000 X 2.5%)/365= ₹6.92. Again on day 2, the investment value becomes ₹99500, the expense ratio on day 2 is likely to be (₹99500 X2.5%)/365= ₹6.82 and so on.
Thus, you can see this expense ratio is not charged by the AMC upfront but it is being charged on a daily basis based on your investment value. If your fund has delivered 15% CAGR and expense ratio is 2.5 %, your expense ratio adjusted return is 12.5%.
Does the mutual fund expense ratio impact fund returns?
There is no doubt to acknowledge that a higher expense ratio means little lesser profits on your investment and vice versa. Mutual fund expense ratio and fund return have an inverse relationship between them. If one is higher another one is bound to be lower.
The daily Net Asset Value or NAV of a mutual fund is declared after adjusting the expense of the scheme. So, a higher expense ratio impacts the fund returns undoubtedly. Financial experts always warn investors not to take any investment decisions completely based on mutual fund expense ratio.
This may cause you a great financial loss to your investment value. Rather, one should analyze, review the expense ratio and if the alpha (return) generated by the mutual fund scheme is lesser than index funds, he should immediately stop investing in that scheme.
What is a good mutual fund expense ratio?
In case of an actively managed mutual fund scheme, the expense ratio is higher than passively managed mutual fund scheme. Just ask one question to yourself, why should I pay high fund management fees for managing my money, if the fund continuously fails to deliver index funds in terms of returns. Does paying a higher expense ratio justify my returns?
So one should focus on fund’s performance, previous track records, fund manager’s track record, and other details. So the crucial criteria should not only be mutual fund expense ratio.
Ideally, a mutual fund expense ratio ranging from 1.5 to 2.5% is considered to be a good option. But as I mentioned earlier that this expense ratio should justify my investment return. Neither a high expense ratio mutual fund scheme with a low return is good nor a low expense ratio fund with a lower return is good too. There should be a perfect balance in it.