Know all about expense ratios, an often overlooked measure

Expenses ratios eat into returns, but are frequently ignored. This measure is also a key factor used for comparing similar funds.

What is a mutual fund’s expense ratio?

The expense ratio of an MF is a percentage of the fund’s assets that is deducted for managing, administering, and operating the fund. It expresses how much an investor pays to the fund every year to manage the money invested. These expenses are deducted from the fund regardless of whether the portfolio has made profits or losses.

What are the charges included under expense ratio?

Primarily, management fee and fund administration expenses—make up the expense ratio of a mutual fund. Out of these, management and advisory fees make the biggest dent. Expenses incurred on operational participants like the custodian and auditors, registrar and transfer agents, along with marketing expenses, are also included.

How does this work out?

Consider this: Mr. A invests Rs 5,000 in a mutual fund. This fund states that its expense ratio is 2%. Putting this in perspective, Mr. A invested Rs. 5000 and assuming a year later the fund returned 12%. This should ideally work out to Rs 5,600 in Mr. A’s pocket. But we need to factor in the expense ratio of 2%, so Mr. A’s actual return would be considered after a deduction of 2% on Rs 5,600 (which works out to total returns of Rs 5,488). This means that Mr. A’s return is not actually 12%, but 9.76%.

Is it worthwhile to be bothered over a small percentage deduction?

It is absolutely necessary to consider an investment from the expense ratio point of view mainly because of two reasons. First, over the long run, 2% forms a substantial chunk of the pie. See table below:

(Returns assumed at 12% p.a)

By the third year, the difference in percentage return is already 8% and the gap will only keep growing as the years go by.

Second, if a fund returns 15% in a year, one may not be too bothered with the expense ratio, but if a fund returns anything lesser than 10%, the expense ratio will feel like a big pinch. Further, all investments are always subject to market risks so even if a fund gives a good return now, it may not sustain its performance going ahead… but the expense ratio will always be charged.

What does this imply?

A lower expense ratio means that the investor gets to keep a greater portion of the returns generated by the fund. So lower the expense ratio, higher the returns in the hands of the investor. Also, one should also consider expense ratio while choosing between two similar fund options.

What is SEBI’s view on expense ratios?

SEBI has set a ceiling for the expense ratio that can be charged. Equity mutual funds cannot have an expense ratio of more than 2.5% of their average weekly net assets. With debt funds, the ceiling is 2.25%. Index funds and fund-of-funds have a cap of 1.5% and 0.75%, respectively. Different funds may have different expense ratios within the stipulated limits.