Mutual Fund Expense Ratio – Calculation and Limits

If you are familiar with the working procedure of mutual funds, you would be aware that these funds are managed by their respective Asset Management Companies (AMC). Of course, expert fund management services offered by AMCs are not free of cost.

They levy various charges on their investors for managing the assets, one of which is the mutual fund expense ratio. But what is it, and how does it work? Let’s find out!

Introduction to Mutual Fund Expense Ratio 

The mutual fund expense ratio is a percentage of the fund’s Net Asset Value at the closing of a trading day. It is an annual charge levied by an AMC on the investors for covering the expense of managing, advertising, and administrating the fund.

It is basically an aggregate of all the expenses incurred by the AMC to run and constantly manage that mutual fund on behalf of the investors.

How Is Mutual Fund Expense Ratio Calculated?  

The following formula is used to derive the expense ratio of a mutual fund: 

• Here, AUM stands for Assets Under Management which depicts the total value of all investors’ money in that fund. 
• The total expense includes all those costs borne for management, marketing, legal/audit formalities, etc. 
• Expense ratio is a percentage that is calculated annually but charged on the basis of how many days an investor remains invested in the fund. It is levied at the closing of every trading day. 
• An investor shall be liable to pay the expense ratio irrespective of whether his returns for a particular day were positive or negative.

How Does Mutual Fund Expense Ratio Work? – Example 

Let’s say you invested ₹10,000 in a mutual fund. On the first day, the NAV of the fund closed at ₹11,000, and on the 2nd day, it closed at ₹10,500. The assets under management of the mutual fund is ₹1000 crore and total cost of the fund stands at ₹25 crore. Now the calculation will be as follows:

Using the formula mentioned above, expense ratio will be (₹25 crore/ ₹1000 crore)X100 = 2.5%. This means that every investor needs to pay 2.5% of the NAV at the time of closing for every trading day. Now let’s calculate the expense ratio to be deducted from your account for these two days:

Day 1. (₹11000 *2.5%)/365 days = ₹0.75

Day 2. (₹10,500*2.5%)/365 days = ₹0.72

This means that you will have to pay ₹0.75 and ₹0.72 as mutual fund expense ratio for Day and Day 2, respectively. This will continue for the number of days you hold your funds. Irrespective of whether you make a profit or loss, you are liable to pay the expense ratio each day. 

Limits Prescribed on Mutual Funds Expense Ratio by SEBI

Currently, in India, there is no limit on any particular type of expense related to a mutual fund as long as the total expense ratio is within the prescribed umbrella limit. As per Regulation 52 of SEBI Mutual Fund Regulations, the limits on total expense ratio (TER) effective from April 1, 2020, are:

It is clear that the total expense ratio depends on the AUM of the mutual fund. In order to protect the interest of the investors, this limit is applicable for both the percentage of expenses that can be incurred and the percentage that can be levied on the investors. 

Why Should You Check the Mutual Fund Expense Ratio?

The difference in the expense ratio of two mutual funds can make a huge difference in your net profit at the time of redemption. If you do not take it under consideration along with your expected profits, it could turn out to be a loss-making deal for you. 

The mutual fund AMC deducts the expense ratio before disbursing the profits to its investors. So if your fund charges a higher fee, then you will receive lesser profits, irrespective of the returns generated by your investment. Not to forget, your mutual fund returns are also liable to taxes. Therefore, make sure you do the math in advance.

Things to Keep in Mind about Mutual Fund Expense Ratio 

If you have come so far, you must have understood the importance of expense ratio while investing in mutual funds. Here are a few extra points that you might want to remember about it.

1. A high expense ratio does not mean better management or higher returns. Even funds with a lesser expense ratio can generate good returns.
2. The mutual fund automatically deducts the expense ratio amount from your NAV on every trading day. You don’t need to pay it separately.
3. Debt funds are likely to get more affected by expense ratio because their returns are also generally limited. 
4. An expense ratio levy of 0.5% – 0.75% can be considered a good expense ratio. 
5. There is an inverse relation between your expense ratio and net returns. Higher the expense ratio, the lesser you will get in returns.
6. Passively managed funds like index funds and exchange-traded funds charge the least percentage of expense ratio. It is because they do not require a lot of strategy or planning as compared to actively managed mutual funds. 
7. All mutual funds are obligated to disclose the TER of all their schemes daily. This information is to be published on their website and the official website of the Association of Mutual Funds in India.

Conclusion

Investing in mutual funds is a smart way to generate returns on your money. However, what is not smart is just blindly putting in your money without making any analysis.

Like for every other financial instrument, do some research for investing in mutual funds as well. Associated charges like mutual fund expense ratio, exit load, etc., are important numbers that you should consider before investing in any mutual fund.