What Is Expense Ratio?
Expense ratio is the annual maintenance charge levied by mutual funds to finance its expenses. It includes annual operating costs, including management fees, allocation charges, advertising costs, etc. of the fund.
Value of an expense ratio depends upon the size of the mutual fund in question. A fund operating with a smaller pool of financial resources has to allocate a certain proportion towards optimal management. This thereby increases the relative value of the expenses concerning the total amount of funds available.
In case of large-cap mutual funds, on the other hand, the amount reserved to meet the expenses is a smaller subject to the total asset value. Therefore, expense ratios have an inverse relationship with size of the respective mutual fund.
This can be depicted by the expense ratio formula, given by total expenses divided by total assets of the funds. Higher the asset base, lower will be the ratio, and vice-versa, given total costs remain constant.
What are the Components Of Expense Ratio?
Workings of a mutual fund are complex, with numerous factors playing a significant role in behind its successful performance. Complete information about these costs and its breakups are released to the investors, to ensure transparency. These charges are revealed via a statement every 6 months, depicting the amount deducted from the account of the investors to meet these costs.
Various types of charges present in a mutual fund expense ratio are –
- Management fees
This charge is allocated towards the payment of the people responsible for the operation of a mutual fund. Portfolio and fund managers devote considerable time and energy to determine profitable investment opportunities through rigorous market research and calculated predictions.
Generally, 0.5-1% of the total asset base is deducted as management fees of a mutual fund.
- Maintenance expenses
Total cost incurred to ensure smooth operations and other administrative duties are added to this tab. Maintaining proper records of the investors, entry and exit fees of the portfolio assets, customer support, etc. can be categorized under the maintenance costs of a mutual fund.
- 12B-1 fee
This represents the amount spent on the promotion of the relevant mutual fund. Creating an adequate asset base requires information which has to be spread among the masses regarding the same. The charge of a new individual investing in the mutual fund is also calculated under the 12-b FEE, and thereby, a component of the total expense ratio of the fund.
- Entry Load
It is the amount that has to be paid by an investor while joining a mutual fund. This reduces the total disposable income over which a person earns interest.
Different mutual funds charge different percentages on entry, at the discretion of the concerned asset management company. However, as per recent SEBI regulations, the entry load is abolished from the calculations of the total expense ratio of a mutual fund.
- Exit Load
Similarly, exit load is the amount payable when a person chooses to withdraw from a mutual fund. This charge is payable on the total investment of an individual, usually standing at 2-3%. This is used as a tool to discourage people from withdrawing funds from a mutual fund.
- Brokerage fees
Mutual funds can be of two plans – direct or regular. In case of regular plans, an asset management company (AMC) hires a broker for all the transactions to be processed concerning the purchase and sale of the shares of the portfolio asset. Direct mutual funds, on the other hand, process these transactions by themselves.
Brokerage fees add on to the expense ratio of a regular mutual fund, while direct funds do not have this burden. Mutual fund expense ratio list of every such fund is readily available on the official website, thereby allowing potential investors to have complete knowledge about the product blocking a substantial amount of their finances.
Expense ratios also depend upon the duration and maturity of a mutual fund. The details regarding these can be easily viewed directly from the official website of the mutual fund you wish to purchase.
How Does the Expense Ratio Impact Fund Return?
Expense ratios are usually deducted from total revenue generated by a mutual fund, before disbursing it to the investors. Higher expense ratios imply a higher proportion of the returns being removed, thereby providing lower returns on investments.
Since expense ratios levy a burden on annual returns earned, an investor should carefully analyse the same while choosing a mutual fund scheme to invest.
Expense Ratio Implications
It is a common misconception that a higher expense ratio indicates better management of a mutual fund, with a higher probability of generating profits. Mutual funds which have a low expense ratio, but managed by trained managers with proper market predictions can yield high returns as well.
Mutual funds having a high expense ratio, on the other hand, can be aggressively managed for higher yields, or invest in companies having a higher probability of earning profits. A more substantial revenue generated will compensate for the higher expenses incurred.
Expense Ratio Limit by SEBI
Expense ratios charged by an asset management company on their mutual funds are subject to certain restrictions imposed by the Securities and Exchange Board of India (SEBI), to protect the interests of investors. This ensures a substantial flow of financial resources to capital market of the country.
The rules are different for Exchange Traded Funds and Index Funds. For an initial asset base of Rs. 500 Crore of such a fund, a maximum total expense ratio of 2% is levied. For next Rs. 250 Crore, if any, a ratio of 1.75% is imposed, while any asset base higher than that is processed at 1.5% respectively.
Under Section 52 of the SEBI Mutual Fund Regulations, an asset management company can charge a maximum of 2.5% as the total expense ratio for the first Rs. 100 Crore of the portfolio value. For subsequent asset value of Rs. 300 Crore, a rate of maximum 2.25% is deductible, while 2% can be charged on subsequent slabs concerned with the rest of asset value.