What is Expense Ratio? Components, Types, Formula, Impact, Implications, Good Rate & Example

What is Expense Ratio?

Expense ratio is a fee charged by mutual funds, exchange-traded funds (ETFs), and other investment vehicles to finance their expenses. The expense ratio is expressed as a percentage of the fund’s average net assets, and it covers the costs of investment management, administration expenses, marketing expenses, and other operating expenses etc.

Types of Expense Ratio: – There are mainly two types of expense ratio:

1. Gross Expense Ratio: Gross expense ratio is the total annual expenses of a mutual fund, including management fees, administrative expenses, operating costs, and all other costs, expressed as a percentage of the fund’s total assets.
2. Net Expense Ratio: Net expense ratio is the gross expense ratio minus any expense waivers, reimbursements, or recoupments. The net expense ratio is the actual cost incurred by the investor and is a more accurate representation of the cost of owning the fund.

Components of Expense Ratio:

1. Management fees: This is the compensation paid to the investment advisor for managing the fund’s portfolio. The management fee is typically the largest component of the expense ratio.
2. Administrative expenses: These are the expenses incurred by the fund for record-keeping, accounting, legal, and other administrative services.
3. Operating expenses: These are the costs associated with running the fund, such as custody fees, transfer agent fees, and audit fees.
4. Distribution and marketing expenses: These are the expenses associated with promoting and selling the fund to investors, such as advertising costs and broker commissions.
5. 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: Exit load is the amount payable when a person chooses to withdraw his amount from a mutual fund. This charge is payable on the total investment of an individual, usually standing at 1-3%. This is used as a tool to discourage people from withdrawing funds from a mutual fund.
• Other expenses: These are any other expenses not included in the above categories, such as taxes, interest expenses, and foreign transaction costs.

Formula of Expense Ratio:

The formula to calculate expense ratio of a mutual fund is:

Expense Ratio = (Total Fund Expenses / Average Net Assets) x 100%

The “Total Fund Expenses” including all expenses incurred by the fund, such as management fees, administrative expenses, operating costs, marketing expenses and distribution expenses.

The “Average Net Assets” is the average value of the mutual fund’s assets under management (AUM) over a specified period, usually a year.

For example, if a mutual fund has total expenses of Rs. 10 crore and an average net asset value of Rs. 500 crores, the expense ratio would be:

Expense Ratio = (10 crore / 500 crore) x 100% = 2.0%

So, the expense ratio for this fund is 2.0%. It means that for every Rs. 100 invested in the fund, Rs. 2 will be deducted as expenses.

How Does the Expense Ratio Impact on Fund Return?

The expense ratio can have a significant impact on a fund’s return, because it reduces the total return earned by investors.

For example, suppose two funds have the same average annual return of 8%, but one fund has an expense ratio of 1% while the other fund has an expense ratio of 0.5%. In that case, the fund with the lower expense ratio will give higher return to investors. The reason is that the higher expense ratio means a greater percentage of deduction for paying fees and expenses and leaving less for investors.

Over the long term, the impact of a higher expense ratio can be significant. For example, over a 30-year period, a difference of just 1% in the expense ratio can result in a difference of tens of thousands of dollars or rupees in the final value of the investment.

What are the Implications of Expense Ratio?

The implications of the expense ratio are significant irrespective whether you are individual investors or institutional investors. Example:

1. Individual Investors: For individual investors, the expense ratio directly affects their investment returns. A higher expense ratio means that a greater percentage of their investment returns is going towards paying fees and expenses, leaving less for their investment growth. Therefore, individual investors should carefully consider the expense ratio of a fund before investing and look for lower expense ratios to maximize their investment returns.
2. Institutional Investors: Institutional investors, such as pension funds, endowments, and foundations, also need to consider the expense ratio when selecting funds. The higher the expense ratio, the more it will eat into the returns of the institutional investor’s portfolio. Since institutional investors typically have larger portfolios, the impact of the expense ratio can be significant. Therefore, institutional investors need to look for funds with lower expense ratios to maximize their returns.
3. Competition: The expense ratio also affects competition among funds. Funds with lower expense ratios have a competitive advantage over funds with higher expense ratios, as investors are more likely to choose funds with lower expenses to maximize their returns. This puts pressure on fund managers to keep their expense ratios low, which can ultimately benefit investors.

Examples of Expense Ratio: –

Here are few examples of expense ratios for different types of mutual funds:

1. Large-Cap Equity Fund: The expense ratio for a large-cap equity fund may range from 0.50% to 1.50%, depending on the fund’s investment strategy, size, and other factors. For example, the expense ratio for the HDFC Top 100 Fund as of September 2021 is 1.74%.
2. Mid-Cap Equity Fund: The expense ratio for a mid-cap equity fund may range from 0.75% to 2%, depending on the fund’s investment strategy, size, and other factors. For example, the expense ratio for the Franklin India Prima Fund as of September 2021 is 1.82%.
3. Small-Cap Equity Fund: The expense ratio for a small-cap equity fund may range from 1% to 2.50%, depending on the fund’s investment strategy, size, and other factors. For example, the expense ratio for the SBI Small Cap Fund as of September 2021 is 1.82%.
4. Debt Fund: The expense ratio for a debt fund may range from 0.20% to 1%, depending on the fund’s investment strategy, size, and other factors. For example, the expense ratio for the Aditya Birla Sun Life Banking & PSU Debt Fund as of September 2021 is 0.27%.
5. Index Fund: The expense ratio for an index fund is typically lower than actively managed funds and may range from 0.05% to 0.50%. For example, the expense ratio for the Nippon India ETF Nifty BeES as of September 2021 is 0.05%.

What is Expense Ratio Limit by SEBI?

In India, the Securities and Exchange Board of India (SEBI) has set certain limits on the expense ratio of mutual funds. As of September 2021, the following expense ratio limits apply:

1. For equity-oriented funds, the maximum total expense ratio (TER) is 2.25%.
2. For debt-oriented funds, the maximum TER is 2%.
3. For index funds or exchange-traded funds (ETFs), the maximum TER is 1%.

Good Expense Ratio for a Mutual Fund:

A good expense ratio for a mutual fund can vary depending on the type of fund and its investment objectives. However, as a general rule of thumb, a good expense ratio for a mutual fund is typically considered to be around 1% or less.

It’s important to compare the expense ratios of different mutual funds within the same asset class to make an informed investment decision. Additionally, it’s essential to consider other factors such as the fund’s historical performance, risk profile, and investment strategy.

Bottom Line of Expense Ratio: – The bottom line of the expense ratio is that it represents the total cost of owning and managing a mutual fund or ETF. The expense ratio is calculated as a percentage of a fund’s average net assets and includes all expenses incurred by the fund, such as management fees, administrative expenses, operating costs, Marketing Expenses and distribution expenses etc.

While the expense ratio can seem a small percentage, but it can have a significant impact on a fund’s performance over time. A high expense ratio can eat big part of investment returns, while a low expense ratio can help boost returns in long term.

As an Investor you should carefully review a fund’s expense ratio and other fees before investing. They should also consider other factors such as the fund’s investment strategy, track record, and risk profile before making an investment decision because expense ratio cannot be single parameter to analyse any fund performance. Ultimately, the goal is to find a mutual fund or ETF that provides a balance of low fees, strong performance, and appropriate risk for the investor’s individual goals and circumstances.