Mutual fund schemes collect money from investors with identical investment objectives and use it to invest in stocks, bonds, and more. When the invested assets perform well, the net asset value of mutual funds increases, making it profitable for investors like you.
However, operating a mutual fund scheme involves expertise and knowledge, for which Asset Management Companies (AMC) employ fund managers.
Are you aware that you are responsible for the fees these managers charge? Also, any other charges that a mutual fund incurs, are also charged to you. This charge is also known as the ‘Expense Ratio.’
In this article, we will cover what is expense ratio and how to calculate the expense ratio in mutual funds.
What is the Expense Ratio?
The expense ratio in mutual funds measures the total costs associated with managing and operating the fund, expressed as a percentage of the fund’s average net assets.
It includes administrative costs, management charges, and other operational expenses. T
The significance of the expense ratio lies in its direct impact on investment returns. A higher expense ratio reduces the net returns for the investor, while a lower expense ratio allows for potentially higher net returns.
Here are the main components of an expense ratio, which you need to know if you wish to learn how to calculate the expense ratio in a mutual fund.
Maintenance Fees
Maintenance fees in mutual funds cover the costs associated with smooth operations and administrative tasks. This includes managing investor records, providing customer support, handling fees associated with portfolio assets, and all crucial expenses necessary for the fund’s efficient functioning.
Management Fees
Management fees are the charges a fund manager applies for handling an investment portfolio. These fees, which include costs for investment analysis, portfolio management, and trading, are assessed as a percentage of the assets under management. Lower fees may lead to increased returns for investors.
Brokerage Fee
A brokerage fee is the amount credited to an intermediary account, which can be an investment advisor or a brokerage firm. These intermediaries are responsible for transacting fund units on your behalf. These fees can be one-time or ongoing and may vary depending on the broker and the type of mutual fund.
12B-1 Fee
A 12B-1 fee is an annual charge by mutual funds, considered an operational expense. It is used for marketing and distribution and is part of the fund’s expense ratio. The fee varies from 0.25% to 0.75% of a fund’s net assets.
Entry Load
Entry Load in a mutual fund is a fee charged when an investor buys units of the fund. It usually represents a percentage of your investment in the relevant scheme. This fee was used to cover distribution costs. However, since August 2009, the Securities and Exchange Board of India (SEBI) has abolished imposing entry loads on mutual funds.
Exit Load
It is a fee charged when you redeem your investment before a specified period, usually a year. It discourages early withdrawals and helps cover administrative costs. The amount varies by fund and timeframe but aims to protect long-term investors by discouraging short-term exits.
How to Calculate Expense Ratio in Mutual Funds?
Here are the steps involved in how to calculate expense ratio in a mutual fund.
- Step 1: Note down the fund’s operating expenses. The scheme’s annual report provides this information.
- Step 2: Identify the fund’s average net assets for the same period.
- Step 3: Divide the fund’s operating expenses by the fund’s average net assets.
- Step 4: Multiply the result by 100 to get the Expense Ratio as a percentage.
The formula is as follows:
= (Total Fund Operating Expenses ÷ Average Net Assets) × 100
Example:
If a mutual fund scheme incurs total operating expenses of Rs 20,000 with average net assets of Rs 20,00,000 during the same period, the expense ratio would be:
= (Rs 20,000 ÷ Rs 20,00,000) × 100
= 1%
This means that for every Rs 100 invested in the fund, the fund’s operating expenses would cost Rs 1 per year.
SEBI Guidelines on Expense Ratio
According to SEBI regulations, fund houses can charge a maximum TER of 2.25% for equity schemes and 2.00% for index and debt schemes. These limits are predefined and aim to regulate mutual funds effectively.
SEBI has also defined sub-limits for TER based on the size of the assets that the fund house manages. That means larger funds may have different TER limits than smaller funds.
SEBI permits fund houses to charge an additional 0.30% (30 basis points) on top of the prescribed limits for sales made in cities outside the top 30 in India. This encourages mutual fund companies to expand their reach to smaller cities and towns.
Recently, SEBI proposed changing the expense ratio uniform for all schemes within a category, such as equity or debt. This proposal aims to prevent mis-selling by distributors and ensure fair practices in the mutual fund industry.
Conclusion
Understanding and calculating the expense ratio is crucial for mutual fund investors, as it directly affects your investment returns.
By knowing the expense ratio, you can assess the cost-effectiveness of a fund and make informed decisions. Lower expense ratios allow for better net returns, which you should consider for choosing a mutual fund for investment.
