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Understanding the Importance of Mutual Fund Expense Ratio

When you invest in a mutual fund, the asset manager charges an annual fee to manage your investment known as the expense ratio. Read on to know about the expense ratio, its components, and its significance while investing in mutual funds.

What is an Expense Ratio

While managing your investment, the Asset Management Company (AMC) incurs expenses like advertising expenses, management fees, administrative expenses, transaction and brokerage costs, registrar and audit fees, etc., to ensure promising returns on your investment. For these services, they charge an annual fee in the form of a percentage of your assets, known as the expense ratio.

To obtain the Total Expense Ratio (TER), the asset manager divides the fund's total expenses by its assets. Before calculating and reporting the Net Asset Value (NAV) of a mutual fund, the asset manager deducts these expenses daily.

Components of the Expense Ratio:

As mentioned above, the TER accounts for several services to ensure the smooth operation of mutual funds. Let's look into some of the major components of the expense ratio:

  • Management Fees

    The asset manager and his team offer continued service and efforts to maximise the profits on your investment. Management Fee is the payment made to your fund house in exchange for their professional expertise for managing your mutual funds. Usually, between 0.5% - 1.0%, this component forms a significant portion of the expense ratio.

  • 12B-1 Fee

    A fund house follows marketing and promotional activities to expand its asset base. 12B01 fee represents the expenses incurred for promoting the mutual fund.

  • Maintenance or Administrative Fees

    Managing your mutual fund requires routine operational tasks like record-keeping, customer support, etc. All these regular activities contribute to the maintenance or administrative fees charged by the fund house.

  • Brokerage Fees

    When you opt for a mutual fund, you can either purchase it directly from the AMC or through a broker. The brokerage fee is the expenses incurred by the AMC to hire a broker to process the transactions during the purchase and sale of mutual funds.

  • SEBI Limit on Mutual Funds Expense Ratio:

    The Securities and Exchange Board of India (SEBI) regulates the mutual funds managed by an AMC. An AMC must comply with the limits on TER as per the Regulation 52 of the SEBI Mutual Fund Regulations as tabulated below:

    Weekly Net Assets on Equity Schemes (in Crores) Maximum TER Allowed
    0 – 100 2.5%
    100-400 2.25%
    400-700 2%
    Above 700 1.75%

For debt schemes, SEBI lowers the maximum TER by 0.25% than equity funds in their respective slabs. And, to increase the reach of mutual funds in tier-2 and tier-3 cities, SEBI allows AMC to charge more by up to 30 basis points (0.3%).

Role of Expense Ratio in Returns

Expense ratio shows what fraction of your returns goes into the pockets of your asset manager. For example, if you invest Rs. 1 Lakh in a mutual fund with an expense ratio of 1%, you must pay Rs. 1000 to your fund house for managing your mutual funds. If your mutual fund grows by 13%, you will receive 12% returns after deducting 1% as the expense ratio.

Lower Expense Ratio Vs. Higher Expense Ratio:

Just as buying the cheapest mobile is not always the best option, the same logic applies to mutual funds as well. On the onset, it would appear that a lower expense ratio means more profit and vice-versa. However, a higher expense ratio merely means that you pay more to your asset manager, and does not necessarily mean lower returns on your investment.

You must understand that the returns on your investment depend upon how wisely your fund manager picks stocks. If an AMC generates higher yields on your mutual funds, it can easily compensate for the higher TER.

Should You Select Mutual Funds Based on their Expense Ratio?

Although the expense ratio is crucial and affects the NAV, it should not be the only criterion for selecting a particular mutual fund scheme. Selecting an AMC with a consistent history of yielding good returns proves beneficial in the longer run. Rather than worrying about the amount you pay to an AMC, research on what it does with your money. Hopefully, by utilising the points discussed above, you will be able to select the best AMC for investing in mutual funds and maximise your profits.