What is Expense Ratio: Everything You Need to Know| North Loop Official Blog
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27 Mar 2020

What is Expense Ratio: Everything You Need to Know

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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:

Management Fee
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.

12B-1 fee
This fee is the amount a fund spends on promoting itself to the general public.
Exit Load
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.

Maintenance Expenses
These are the operational costs of the fund - customer support, administrative expenses, rent etc. It is critical that a fund runs smoothly.

Brokerage Fees
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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This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended be advice. You must obtain professional advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax, investment or other professional advice from North Loop or its affiliates. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date. All opinions expressed do not reflect the views of North Loop nor are endorsed by North Loop.