Does the Expense Ratio in Mutual Funds Affect Your Portfolio Returns?

September 12, 2022 Mutual Fund

Every business involves costs and charges that are typically transferred to the end user. Similarly, investing in mutual funds isn’t free; it comes at a cost. By conducting careful research and analysis, the mutual fund houses and the fund management teams carry out the crucial task of choosing where and how to invest the corpus gathered from the investors. Such investing choices greatly impact how well mutual fund schemes perform and, ultimately, how much return they generate.

In order to manage a mutual fund scheme, there are various expenses or costs that an Asset Management Company (AMC) (or a fund house) incurs. This includes registrar fees, transfer fees, custodian charges, brokerage on buying and selling securities, agent commissions, legal and audit fees, management expenses, advertising, and marketing fees, maintaining proper records of investors, etc. All these costs contribute to the fund’s expenses and are charged to the investor as a Total Expense Ratio (TER) or Expense Ratio that is disclosed on a daily basis.

What is an expense ratio in mutual funds?

The annual maintenance fee charged by mutual funds to cover their costs is known as the expense ratio. All unit holders in the plan are evenly charged the same amount per unit as the cost of managing the scheme. The specified mutual fund’s Daily Net Assets are used to calculate the expenses. The expense ratio in mutual funds is deducted from the fund’s total assets prior to determining your NAV.

Depending on how much it costs to operate and manage the fund, the expense ratio may vary from one scheme to another. The fact that all costs associated with mutual funds are fully regulated by the Securities Exchange Board of India (SEBI) is an intriguing aspect of these costs. Additionally, there are no restrictions on the nature of charges as long as the expense ratio is within the SEBI’s permitted range.

The guideline rates are given by the regulator; thus, no AMC can levy any charges which are outside the purview of those prescribed by SEBI. The Association of Mutual Funds in India (AMFI) and the AMC’s websites both display this information, and it is also widely accessible in the public domain.

How is the expense ratio in mutual funds calculated?

The expense ratio is derived as a percentage by dividing the scheme’s total expenses by the total assets under management (AUM) and adjusted in the scheme’s prevailing NAV, while investors do not have to pay it separately.

The expense ratio in mutual funds can be calculated using the following formula;

Total Expense Ratio (TER) = (Total Expense of the scheme during the period/Total Assets under management) * 100

If the mutual fund scheme holds an AUM of Rs 10 lacs and collects Rs 15,000 in fees and other charges from the fundholders, then the expense ratio is 1.5%

Expense ratio = Total Expenses/Total Assets= Rs 15,000 /10 lacs *100 = 1.5% of your Investment Value.

For instance, if you invest Rs.10,000 in a mutual fund scheme of your choice with an expense ratio of 2%, then you are paying the fund house Rs 200 to manage your money. It can be said that if a fund earns 10% and has a 2% TER, then it means an 8% return for an investor. The mutual fund’s NAVs are reported after netting off the fees and expenses, and hence, it is necessary to know how much the fund is deducting or charging as expenses.

Under regulation 52 of the SEBI Mutual Fund Regulations, the regulatory limits of the expense ratio that can be charged by the AMC/fund house have been specified as below:

Table 1: Total Expense Ratio (TER) limit for actively managed equity and debt mutual funds

(Source: www.amfiindia.com)  

In addition, SEBI has also prescribed the maximum TER limit for passively managed mutual funds, such as index funds, fund of funds, Exchange-Traded Funds (ETFs), and close-ended funds.

Table 2: Total Expense Ratio (TER) limit for passive mutual fund schemes

  (Source: www.sebi.gov.in)

Mutual fund expense ratios range from 0.1% to 3.5% for tax-saving mutual funds in India.

How does the expense ratio in mutual funds impact your portfolio returns?

Expense ratios have a proportional impact on mutual fund returns. In the long term, even a tiny change in expense ratio might cost you a lot of money. Mutual fund returns are computed on the NAV after the expense ratio is taken into consideration. Expenses are deducted from your fund on daily basis before calculating the NAV. Your capital gains are also calculated after deducting your expenses. As a result, after removing all costs, the returns you see on the NAV are the returns you actually receive as an investor.

Expense ratio in mutual funds depend on the level of involvement of the fund management team. It is for this reason that expense ratios are higher for actively-managed categories such as equity-oriented mutual funds, and lower for passively managed funds such as ETFs/Index funds due to limited intervention by the fund managers.

There are two different types of plans in a mutual fund scheme: Direct and Regular, which is another aspect that affects the expense ratio. The investor may prefer to opt either of these plans as per their suitability. Due to the fact that investors purchase units directly from the fund provider, the direct plan does not pay a commission to a broker or agent. The regular plan, on the other hand, includes the distributors’ commission and pays it to an intermediary like a distributor of mutual funds. Therefore, the expense ratio in mutual funds of a direct plan will probably be lower than that of the regular plan.

Since the expense ratio is taken out from your investment, it is perceptible that higher the expense ratio, the lower will be your returns and vice versa. It is a common misconception that a higher expense ratio indicates a better-managed scheme or earns higher returns. A scheme with a lower expense ratio could be equally or more capable of earning higher returns. The expense ratio of a number of mutual funds with higher AUM is expected to be lower as more participants share the management costs.

The expense ratio could be a significant deciding factor when choosing the best mutual fund. Higher expense ratios in mutual funds imply higher proportion of the returns being removed, thereby providing lower returns on investments. An investor should prudently analyse the expense ratio when deciding to invest in a mutual fund scheme because it has an impact on the annual returns generated by your portfolio.

For both the lump sum and Systematic Investment Plan (SIP) modes of investment, the expense ratio in a mutual fund scheme remains the same as it is charged daily for the duration of your investment. As a result, even if you cease making SIP contributions and still holding plan units, you continue to be assessed an expense ratio.

To conclude…

Expense ratios are an important factor in determining the overall cost of your investments, but they shouldn’t be the only factor used to select or reject a fund; other qualitative and quantitative criteria must also be taken into account. It’s possible that a scheme with a solid track record will provide you with different information concerning the total expense ratio. It will be incorrect to assume that the mutual fund scheme with the lowest expense ratio will be the best performer. Sometimes, the decent returns the scheme generates may be overshadowed by the higher expense ratio.

The role of expense ratios is very limited in the overall wealth-building exercise. Your portfolio’s returns will be influenced by a number of factors, including the expense ratio, the mutual funds you choose, and how frequently you review your portfolio. Notably, your decision should be primarily based on your risk appetite, investment objectives, and investment horizon. If you have the expertise and time to choose the right funds and undertake other investment decisions, you can consider investing in direct plans as they have a relatively lower expense ratio compared to regular plans.

Moreover, if you are a risk-averse investor, you may consider investing in passively managed mutual funds like Index funds or ETFs. Since passively managed funds carry lesser management costs, the expense ratio is lower compared to actively managed funds. Additionally, you should be aware that frequently buying and selling mutual fund units can increase overall expenses in the form of exit loads and short-term capital gains tax.

Therefore, it is wise to choose worthy mutual funds with a long-term approach to achieve your investment goals. Make sure your mutual fund pick is not just based on a lower expense ratio; instead, consider factors such as past performance, the fund manager’s level of experience, the fund house’s credibility, etc.

Happy Investing!

This article first appeared on PersonalFN here