What is Expense Ratio - Overview
f you’re investing in a mutual fund, you will likely see an expense ratio associated with it, often expressed as a percentage e.g. Expense Ratio - 1%. So what is expense ratio, and what does it mean for you?
An expense ratio is an annual charge a mutual fund will charge. It’s an annual maintenance charge for investing in a mutual fund, and is shown as a percentage of the amount you invest in the fund. For example, if you invest Rs. 10,000 in a mutual fund with an expense ratio of 1%, you will be charged Rs. 100 every year.
How Mutual Funds Work
A mutual fund invests your money into a variety of investments, depending on the focus of the fund e.g. equity funds, debt funds etc. The fund manages your investment, and gives you a return on your investment. Mutual funds are extremely popular in India due to their benefits for saving for retirements or your family.
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How Mutual Funds Make Money - Expense Ratio
A mutual fund will take the income from its expense ratio and use it to finance its operations. These include paying salaries, operating costs etc.
What is a good or bad expense ratio?
There is no such thing as a good or bad expense ratio, as it very much depends on what you’re looking to invest in. Some funds charge a higher rate than others. What matters most is the returns of the fund, and if the fund is diversifying your portfolio to reduce risk. Therefore, a fund with returns of 15% and a 1% expense ratio will give you more in returns than a fund with 10% returns and 0.5% expense ratio.
A larger fund will be able to charge a lower expense ratio than a smaller fund. This is due to the simple mathematics of scale - since a larger fund manages more money, it is making more through its expense ratio, and therefore can cover its costs with a lower ratio since it is making a larger amount overall. For example, 0.1% of 10,000,000 is more than 1% of 1,000.
How Does the Expense Ratio Impact Fund Return?
Since the expense ratio will be deducted from your returns, you need to subtract the expense ratio from your overall returns of a fund i.e. an expense ratio of 1% will need to be subtracted from a fund’s 10%. This new amount is your TRUE return on an investment in a mutual fund.
Expense Ratio Limit
The Indian regulator, SEBI, has strict guidelines for the maximum amount a mutual fund can charge investors as an expense ratio.
If the initial asset base of a fund is Rs. 500 Crore the maximum the total expense ratio can be is 2%. As the fund grows, the next Rs. 250 Crore a maximum ratio of 1.75% can be applied. After that, if the asset base is higher than Rs. 750 crore, the maximum amount for the funds above Rs. 750 crore are 1.5%. Rules differ for ETFs and Index Funds.
An asset management company can charge a maximum of 2.5% as its total expense ratio for the first Rs. 100 Crore of its portfolio. Then, for the next Rs. 300 crore, a maximum rate of 2.25%. Then, 2% for any amount above Rs. 400 crore.
What is an expense ratio made up of?
An expense ratio is used to fund a variety of costs. Some of these include:
These fees go to the fund and portfolio managers to pay for their salaries. There is a lot of work required to manage a mutual fund, and funds attract the very best of managers to ensure your money is safe and getting the best possible returns.
This fee is the amount a fund spends on promoting itself to the general public.
This is the fee that an investor pays when withdrawing their investment from a total fund. It is usually a percentage of the entire investment amount.
These are the operational costs of the fund - customer support, administrative expenses, rent etc. It is critical that a fund runs smoothly.
There are two types of mutual funds - direct or regular. Regular mutual funds, the asset management company (AMC) hires a broker to buy and sell all the transactions the mutual fund is doing e.g. buy stocks, sell stocks. However, direct mutual funds conduct all these transactions in house.
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