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The expense ratio is the yearly fee that fund houses charge their investors. It is charged especially on those schemes that are actively managed by the fund managers. It is charged as the percentage of your investments. The fund houses charge this ratio annually. It pays for the fund expenses, management fees, administrative fees, operating costs, and all other costs incurred by the fund. Transaction fees, or brokerage costs, as well as initial sales charges, are not included in this ratio. Funds may opt to waive all or a portion of the expenses that make their overall expense ratio. Index Funds are not actively managed by the fund managers that is why expense ratio is not levied on them.
If the fund’s assets are small, its ratio can be quite high because the fund must meet its expenses from a restricted asset base. As the net assets of the fund grow, the expense percentage should diminish as expenses are spread across the wider base.
Expense ratio = Total Expenses/Total Assets
Examples of Expense Ratio
These examples will help you understand the implication and how it is calculated.
Example:
Total Assets of Mutual Funds X(AUM) = Rs 2 Crore
Administrative expenses = 2 Lakh
Other Expenses = 50 Thousand
Expense ratio = Total Expenses/Total Assets
= 2.5 lakh/2 crore
= 1.25% of your Investment Value
When the AUM increases from 2 cr to 5 cr
Total Assets of Mutual Funds X(AUM) = Rs 5 Crore
Administrative expenses =2 Lakh
Other Expenses = 50 Thousand
Expense ratio = Total Expenses/Total Assets
= 2.5 lakh/5 crore
= 0.5% of your Investment Value
Thus, This shows how the expense ratio gets lower when the AUM increases.
Limit By SEBI
All expenses of an AMC must be managed within the limits under Regulation 52 of SEBI Norms. As per these regulations, the total expense ratio (TER) allowed is 2.5% for the first ₹100 crore of average weekly total net assets, 2.25 % for the next ₹300 crore, 2% for the next ₹300 crore and 1.75% for the rest of the AUM.
The limit for debt fund is 2.25%. On top of this, the SEBI allows all the mutual funds to charge 30 basis points(Basis point (BPS) refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%) more as an incentive to penetrate in smaller towns. For instance, you take 50 basis points then the charge would be 0.5 %.AMCs that expand their work to such semi-urban areas also enjoy an additional 20 basis points as exit load charges.
Types
Annual Gross Expense Ratio
It is the percentage of fund assets paid for interest expense, operating expenses, and management fees. The gross ratio includes the following types of fees:
- interest and dividends on borrowed securities
- accounting
- administrator
- advisor
- audit
- the board of directors
- custodial
- distribution
- legal
- organizational
- professional
- registration
- shareholder reporting
- subadvisor
- and transfer agency
The gross ratio does not reflect the fund’s brokerage costs or any investor sales charges.
Annual Net Expense Ratio
The net ratio includes equivalent fees to the gross ratio, but in contrast to the gross ratio, the net ratio is collected after fees are recovered by an advisor. The net ratio does not reflect the fund’s brokerage costs or any investor sales charges.
Prospectus Gross Expense Ratio
It is the ongoing estimated percentage of fund assets paid for operating expenses and management fees. It is collected from the Total Annual Fund Operating Expenses from the fund’s most recent prospectus fee table.
Prospectus Net Expense Ratio
The net expense ratio includes equivalent fees to the gross ratio, but in contrast to the gross expense ratio, the net expense ratio is collected from the Total Annual Operating Expenses after Waiver from the fund’s most recent prospectus fee table. The net expense ratio does not reflect the fund’s brokerage costs or any investor sales charges.
Components of Expense Ratio
Expense Ratio includes numerous charges for smoothly running the mutual fund investment. Funds recover this cost from the mutual fund investors on a day-to-day basis. However, they disclose the costs incurred to the investors once in every six months.
3 major types of expenses are included in the Expense Ratio.
- Management Fees
Mutual funds require the formulation of investment plans before actually investing money in the underlying assets. Fund managers must possess a high level of educational, relevant fund management experience and professional credentials. The management fee or investment advisory fee is compensation for these managers’ expertise. On average, this annual fee is about 0.50% – 1.0% of the funds’ assets.
- Administrative Costs
Administrative costs are the expenses of running the fund. This includes record-keeping, customer support, and service, information emails, communications. They can vary and are expressed as a percentage of fund assets.
- 12-1b Distribution Fees
Many mutual funds collect the 12-1b(12-1b fee is an annual marketing or distribution fee on a mutual fund) distribution fee for advertising and promotional purposes. Usually, they charge their shareholders for marketing and promoting the fund to the investors.
These three fees combined are equal to the expense ratio from the fund.
How Expense Ratio impact Fund Returns
Expense ratios indicate how much the fund charges in terms of percentage annually to manage your investment portfolio. If you invest Rs 50,000 in a fund that has a ratio of 2.5%, then it means that you need to pay Rs 1250 to the fund to manage your money.
Simply put, if a fund earns returns equal to 20% and has a TER of 2.5%, then you would earn a return equal to 17.5%. The Net Asset Value (NAV) of a fund is reported after deducting all fees and expenses. Thus, the TER has a direct bearing on a scheme’s NAV – the lower the expense ratio of a scheme, the higher the NAV.
It becomes important to know how much are you paying to the fund.
Conclusion
Although a high ratio impacts the fund returns, it is not set in stone. If the funds are managed aggressively then high returns can be an outcome of high ratio due to the choice of investment and good stocks in the asset.
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