As an investor, it is essential to understand the expenses associated with mutual fund investments. One of the most significant expense is the expense ratio. The expense ratio is a fee charged by mutual funds to cover their operational costs, including management fees, administrative fees and other expenses. It is a percentage of the mutual fund’s total asset under management (AUM). Mutual funds are legally bound to disclose their expense ratios to their investors.
In this blog post, we will explore the expense ratio. How it is calculated? And why it is higher for regular plan, when compared to a direct plan And how the expenses of mutual funds will impact investors’ returns in the long term.
What is expense ratio?
The expense ratio refers to the fees mutual fund companies charge to manage mutual funds. This ratio depends on the size of the mutual fund.
How expense ratio is calculated?
Expense ratio = Total Annual Expenses / Average AUM
Where:
Total annual expenses are expenses borne by AMCs, including fund managers’ remuneration, distribution outlays, and other legal and audit expenditures.
Average AUM reflects the overall value of funds gathered from all investors in a particular fund.
Let us understand the same with the example for better understanding…
If the mutual fund has a total asset under management of Rs. 10,00,000, and the mutual fund charges Rs.15,000 as an expense for its operating costs, it will have an expense ratio of 1.5%
All schemes have different expense ratios; generally, an equity scheme has a higher expense ratio when compared to a debt scheme.
Why is the expense ratio higher for a regular plan?
In a direct plan, an investor buys units directly from the mutual fund companies without the involvement of a distributor. In contrast, in a regular plan, units are bought through an intermediary (known as a distributor), who is, in turn, paid a commission by the fund house, which is recovered as an expense ratio from the plan. Hence, the expense ratio is always higher in the regular plan.
How does the expense ratio impact returns?
The expense ratio tells you how much a fund house scheme charges annually in terms of percentage to manage your investment portfolio.
If you invest Rs.1 lakh in a fund with an expense ratio of 1%, then you need to pay Rs.1000 per annum to the fund to manage your money. However, you do not directly pay this Rs.1,000 to the fund. Instead, the expense ratio is deducted from the fund’s assets, which reduces the overall return of the fund. The expense ratio is reflected in the daily net asset value (NAV) of the fund. So, you don’t pay it as a separate fee; it is already accounted for in the returns you receive.
Conclusion:
The expense ratio is more than just fees, which impacts the return of investors significantly. Investors must carefully weigh the cost against the benefits offered by a mutual fund, considering their financial goal and risk tolerance.
