What is Expense Ratio in Mutual Funds?

‘Mutual Funds Sahi Hai’ is now a well-known truth among investors.

This is evident in the share of individual investors’ funds in the mutual fund industry’s assets under management (AUM), particularly in equity-oriented funds, as well as the amount of inflows, and the rise in folios.

But like with any investment you make, there is a cost of investing involved in mutual funds. There are no free lunches.

The cost is reflected in the expense ratio.

What is an Expense Ratio?

A mutual fund house incurs several costs to run a scheme.

These include investment management fees, brokerage/transaction costs, administrative expenses, sales & marketing expenses, registrar fees, custodian fees, audit fees, etc.

All these costs are subsumed into what is known as Total Expense Ratio (TER) to manage the fund. The TER is charged as a percentage of the fund’s daily net assets.

Every mutual fund scheme levies a TER.

How is the TER Calculated?

It is calculated as follows:

Total Expense Ratio (TER) = (Total Expenses of the Scheme during the period / Total scheme assets) x 100

Basically, the TER is calculated as a percentage of the scheme’s average Net Asset Value (NAV).

What is the Maximum TER a Fund Can Levy?

The following is the maximum TER that actively managed equity funds and debt funds can levy, as per the SEBI Mutual Fund Regulations.

Assets Under Management (AUM)	Maximum TER as a percentage of daily net assets
	TER for Equity funds	TER for Debt funds
On the first Rs 500 crores	2.25%	2%
On the next Rs 250 crores	2%	1.75%
On the next Rs 1,250 crores	1.75%	1.5%
On the next Rs 3,000 crores	1.6%	1.35%
On the next Rs 5,000 crores	1.5%	1.25%
On the next Rs 40,000 crores	Total expense ratio reduction of 0.05% for every increase of Rs 5,000 crores of the daily net assets or part thereof.	Total expense ratio reduction of 0.05% for every increase of Rs 5,000 crores of daily net assets or part thereof.
Above Rs 50,000 crores	1.05%	0.8%

(Source: www.sebi.gov.in)

In case of the passively managed funds, the TER limits currently are:

• 2.25% for equity Fund of Fund schemes
• 2% for non-equity Fund of Fund schemes
• 1.25% for a close-ended equity scheme or interval scheme
• 1% for non-equity-oriented close-ended or interval schemes, index funds/Exchange Traded Funds ETFs, and Fund of Funds investing in liquid index funds and ETFs

Whether you make a lump sum investment or take the Systematic Investment Plan (SIP) route, these TER will apply.

As long as the TER is within the prescribed limit, there is no limit on any particular type of expense allowed.

The daily NAV that a mutual fund scheme discloses is after deducting the expenses. You do not pay for the expenses ratio separately. 

That said, the TER has a direct bearing on the scheme’s NAV. The lower the expense ratio of the scheme, the higher its NAV.

Want to keep the cost of investing low? Consider direct plans in mutual funds

To invest in mutual funds, you have the option to choose between the Direct Plan or the Regular Plan.

Direct Plan is a way of investing in mutual funds without any intermediary, such as a mutual fund distributor/relationship manager/ agent. In other words, you invest in a mutual fund scheme directly. 

Since there is no involvement of intermediaries and no commissions to be paid, the expense ratio under the Direct Plan is lower than a Regular Plan.

Currently, the difference in the expense ratio under the Direct Plan and Regular Plan of actively managed equity mutual funds ranges between 0.3% to 2.6%, with an average difference of about 1.2%.

Now, while a marginal difference of 0.5-1% may not seem much, over a long period of time, it can impact your returns and the corpus that builds up.

Difference in the Corpus – Direct Plan v/s Regular Plan

	Direct Plan	Regular Plan with 0.5% higher Exp. Ratio	Regular Plan with 1% higher Exp. Ratio
Amount invested (in Rs)	1,000,000	1,000,000	1,000,000
Value after 30 years (in Rs)	29,959,922	26,196,666	22,892,297
Difference (in Rs)	–	3,763,256	7,067,626

The compounded average growth rate is assumed at 12% p.a.

(This table is for illustrative purposes only)

Say you had invested Rs 1 million (m), the illustration above shows that under the Direct Plan, it would have grown to Rs 29.9 m over 30 years, assuming a 12% CAGR.

Had you invested in the Regular Plan, assuming 12% CAGR, even a 0.5% higher expense ratio, the value of the investment would have grown to Rs 26.2 m at the end of 30 years, i.e. Rs 3.76 m less.

So, as you can see, the expense ratio can weigh down on the corpus you build.

Conclusion

TER is one of the important parameters when selecting a mutual fund scheme.

However, a low TER does not necessarily mean that the fund would be good for you. The investment decisions cannot be solely based on TER.

While you need to be conscious of the TER so that the cost of investing is low, you also need to evaluate a host of other factors.

Among them are the returns of scheme (across time period and market phases), risk ratios, the portfolio characteristics top 10 stocks, top 5 sectors, portfolio turnover, etc.), the credentials of the fund management team, the efficiency with which the fund manages its AUM, and the investment process & systems followed.

A mutual fund scheme should be able to justify the expense ratio levied with an appealing performance track record.

And lastly, invest in mutual funds thoughtfully, considering your personal risk profile, your broader investments, financial goals you’re addressing, and the time in hand to achieve those goals.

Avoid investing in an ad hoc manner.

Happy investing.

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