What is Expense Ratio in Mutual Funds? (With Example)

Total Expense Ratio in mutual fund represents the annual charges deducted for its operation. Expressed as a percentage of assets, it includes fees for portfolio management, marketing, administration, and transactions.

Higher expense ratios can significantly impact your overall returns, and it does pay for things like fund management, advertising, marketing, and other associated costs needed to run the fund. Continue reading to understand what is expense ratio in mutual fund with example, along with key factors that can help investors make well-informed investment decisions.

Understanding Expense Ratio from Investor Point of View

As noted earlier,  the expense ratio in mutual fund meaning refers to the percentage of a fund’s total assets allocated to cover management, administrative, and operational costs. This deduction directly affects investor returns, making it a crucial factor in fund selection.

When a mutual fund’s cost is discussed, the term being referred to is often the expense ratio. The factors below will let investors better understand the impact of expense ratio in mutual funds in India.

• Impact on Returns

Higher expense ratios in mutual funds can only result in lower returns. On the other hand, a lower ratio cannot guarantee better performance. Rightly balancing the cost-effectiveness regarding the given fund objectives is the key. As an investor, one must recognize a valid balance between cost and performance to impact returns positively. Having a better understanding of how expense ratios can affect returns provides clarity while accessing the fund to suit your investment needs. 

• Direct vs. Regular Funds

Regular funds distributed through intermediaries incorporate higher expense ratios when compared to direct funds. They can impact long-term returns, emphasising the cost advantage involved in direct investments. As an investor, you must delve into the possible dynamics of the distribution costs. Direct funds having lower expense ratio in mutual funds in India can be a cost-effective choice for investors to make informed investing decisions.

• Comparison Tool 

Expense ratios help compare mutual funds and pick the best one between similar funds. Any fund with a lower expense ratio can be a cost-effective option. Given the investment and return needs, investors need to recognize them as one of the other metrics used to pick the best mutual fund. Although a lower ratio can be favorable, conducting a comprehensive evaluation helps analyze other factors like risk, fund manager expertise, and the mutual fund’s past performance. 

How to Calculate Expense Ratio in Mutual Funds with Formula?

To better understand what is the expense ratio in mutual funds, one needs to learn and utilize the formula as derived for the same. 

Expense Ratio = Total Expense / Average Asset Under Management

Total expense ratio in mutual fund indicates the costs as collected by the asset management company. It has been collected to meet various expenditures like marketing, distribution, legal and audit expenses, and the fund manager’s fees. 

Average AUM is certainly the overall and total value of the investors’ fund as found in a particular scheme. 

Suppose a mutual fund has an average AUM of Rs.100 crore and total expenses of Rs.1 crore.

Expense Ratio = Total Expense / Average AUM

 = Rs.1 crore/ Rs.100 crore

 = 1%

So, if you invest Rs.10,000, you pay Rs.100 annually as an expense.

Basic Components of Expense Ratio

AMC (Asset Management Company) releases information regarding the costs and breakups involved in a fund, offering complete transparency to investors. The various components of the expense ratio include:

• Maintenance Fees: These fees are collected for the operations and administration of the mutual fund schemes. Such collected charges are vitally used in maintaining accurate investor records, determining the possible entry and exit loads, and for customer support purposes.

• Management Fees: Management fees are cleared by people who are said to be responsible for the mutual fund scheme operation. The portfolio and fund managers spend their time and energy to conduct valuable market research that lets them identify and pull in profitable investment opportunities. 

• Brokerage: As an investor, you get to invest in a regular or direct plan. The asset management companies process the direct plan, while the regular plans require hiring services from a broker to process the purchase or sale transactions. The brokerage fees can increase the expense ratios in mutual funds in any regular mutual fund scheme. 

The expense ratio also gets impacted by the pre-derived maturity and duration of the mutual fund schemes. As an investor you must access information related to expense ratio as listed in the AMC website.

Expense Ratio Explained with Example

Let us understand what is expense ratio in mutual fund with example. For example, consider a mutual fund scheme with an expense ratio of 1.25% per year. 

If an investor has invested Rs.1,00,000 in this fund and the investment value increases to Rs.1,00,500 on one day and Rs.1,00,125 on another, the daily expense ratio can be calculated as shown in the table below:

Date	Investment Value of the Day	Expense Ratio
1st of January	Rs. 1,00,500	(1.25% / 365) * 1,00,500 = Rs. 3.44
3rd of March	Rs. 1,00,125	(1.25% / 365) * 1,00,125 = Rs. 3.42

In this case, Rs.3.44 is deducted on January 1st, and Rs.3.42 is deducted on March 3rd, continuing on a daily basis. A small portion of the investment is regularly allocated to cover the expense ratio. 

This daily practice does reduce your returns. Irrespective of your mutual fund returns turning positive or negative, the expense ratio has to be paid until you remain invested in the mutual fund scheme. 

Possible Ways to Find Mutual Funds With Lower Expense Ratios

The expense ratio does play a critical role in shaping your mutual fund investment journey. As demonstrated and explained related to expense ratio meaning in mutual fund, you must have now understood that expense ratio can determine your returns. If you are new to investing in mutual funds, you may find it difficult to pick funds with low expense ratios. Upcoming is a quick guide to finding funds in low-expense ratios. 

• New and experienced investors must consider changing to a passive approach to all their mutual fund investments. 
• Every passively managed fund might have a lower expense ratio when compared to the actively managed mutual funds. Also, it does not require researchers to choose the assets to buy and sell actively. 
• In general, index mutual funds have a low expense ratio as they seek to replicate the performance of popular funds like Nifty 50 or Sensex. These funds are passively managed, and there is no need to derive an investment strategy or to conduct research to meet your investment purposes. This way, you will be ensured of low management costs, leading to low expense ratios.

Conclusion 

Understanding the expense ratio meaning in mutual fund is essential for investors seeking possible returns and cost-effective investments. By remaining aware of the total expense ratio in mutual fund and its components, impact, and formula, you can better understand the overall mutual fund landscape and to make valuable investment decisions that can well align with your financial goal for the year.