What Is Expense Ratio?

In the previous chapter, we learnt about the fund’s performance, and why and how the fund’s performance is evaluated. While learning the steps to evaluate the performance of a mutual fund, we saw that expense ratio plays an important role. In this chapter, we will decode what expense ratio is, what are its components and what role it plays in the index funds and the actively managed funds. We will also take an example to better understand the concept of expense ratio.

Introduction

The other day I was at the bank collecting some documents from the locker and guess who I bumped into? You bet it was Ranjit. These days, the moment Ranjit sees me, he has a question related to mutual fund selection ready to throw at me. Off late, he has been very curious about beginning his investment journey, just how you guys are curious too.

This time around, he asked me about the term he came across on the internet while searching about mutual funds. It was ‘Expense Ratio.’ Ranjit was all perplexed about it. He mistook expense ratio as an evaluation tool similar to Sharpe Ratio. But the confusion is understandable. The term ‘ratio’ can confuse anyone.

But before we begin with the expense ratio, let me get your attention to how the bank locker, or any other account for that matter, works? When you opt for a locker facility at the bank, they charge you certain fees for the maintenance of the locker. Similarly, when you open a DEMAT and trading account with a brokerage firm, they charge you an annual maintenance charge for maintaining your account. A similar concept is applicable in the case of mutual funds.

To operate and maintain a mutual fund, an asset management company needs to have certain expenditures. That expenditure is measured as a percentage of the total assets under management (AUM) of the fund which is called expense ratio. It is nothing different than the maintenance and administration charge for the mutual fund. Let us look at it in detail.

What is Expense Ratio (ER)?

Expense ratio is the charge a fund house levies on the gross returns from the funds for maintaining the portfolio. It comprises many components like fund manager’s fees, operating costs of the fund, promotional and advertising expenditure, etc. Typically, expense ratio is computed in terms of percentage. The formula to compute expense ratio is as follows:

Expense Ratio = Total Cost of the Fund ÷ Total Assets Managed by the Fund

As the denominator for expense ratio is total assets, expense ratio of small funds will be higher and that of large funds will be lower. One can conclude that expense ratio and the size of the fund are inversely related to each other.

As expense ratio reduces the net return earned by the investor, it becomes an important factor to consider before picking the right fund. For the sake of transparency, funds reveal all the expenses incurred by them via a semi-annual report.

Interpretation of Expense Ratio

Expense ratio can be considered as a tool for measuring the cost of a fund house in relation to assets under its management. In simple words, it tells you how much percentage of the asset value is spent by the fund house in maintaining the portfolio.

There are different ways of portraying expense ratio. Some fund houses focus on giving the total amount of expenditure whereas some provide categorised gross and net figures for better clarity about where the money was spent.

The biggest component of expense ratio is fund manager’s fees. And since the fund manager’s remuneration is fixed, the expense ratio does not fluctuate much. Although, each fund has a separate expense ratio and it becomes very important to evaluate each and every component in it.

Components of Expense Ratio

So far we discussed thoroughly about expense ratio and its interpretation. Let us now look at what exactly are the components of expense ratio.

• Fees for Management: This being the main component of the expense ratio, around 1 percent of the value of assets goes towards meeting expenditure on fees and remuneration paid to the management. This includes fees paid to the fund manager.

• Administrative Charges: Maintaining a fund is a complex task. With investors joining and leaving the fund, the administrative work increases and so does the cost. The cost of providing client service is included in this.

• Advertising and Promotional Expenditure: To spread a word about the fund, asset management companies have to incur advertising and promotional expenses. Higher popularity brings a larger number of investors and hence, the overall cost of managing the fund gets divided amongst them all.

• Exit Loads: When the investment in a mutual fund is liquidated, the fund levies a charge at the time of withdrawal. Such a charge is called exit load. Typically, it is around 2% – 3% of the total investment.

Note: Similar to exit loads which are charged at the time of withdrawal, an entry charge is levied at the time of investing in a mutual fund. Such a charge is called entry load. As per the SEBI rules, entry loads are not included to be a part of expense ratio.

Index Funds Vs Actively Managed Funds

There are two types of funds based on its constituents, viz. Passively Traded Funds and Actively Traded Funds. The funds which are actively managed by the fund managers are the regular funds in which equity shares and debt instruments of various companies are invested in. On the other hand, passively traded funds, popularly known as Exchange Traded Funds (ETFs), are the twin copy of a particular index such as Nifty or Bank Nifty.

The expense ratio in case of ETFs is very low since there is no active management required by the fund manager. Actively managed funds require frequent analysis and investment and divestment decisions and hence, expense ratio is higher in such funds.

Example of Expense Ratio

Let us understand what does expense ratio mean with the help of an example for actively managed funds as well as passively managed funds.

• Expense Ratio in case of Actively Managed Fund: Let us assume there is a XYZ Large-Cap Growth Fund. The mutual fund company incurs total expenditure of Rs. 1.5 Lakhs to manage this fund and total asset under management (AUM) of this fund is Rs. 1 Crore. This means that the expense ratio of this fund is 1.5% (Rs. 1.5 Lakhs ÷ Rs. 1 Crore). If you invest Rs. 1 Lakh in XYZ Large-Cap Growth Fund, then you shall be paying a fixed charge of Rs. 1,500 (1.5% of Rs. 1 Lakh) towards expense ratio.

• Expense Ratio in case of Exchange Traded Fund: Suppose there is a Bank Index ETF which comprises all the shares in the Bank Index of the stock exchange. Assuming that the aggregate amount you pay towards exchange charges and other charges sum-up to Rs. 200 and your investment value is Rs. 1 Lakh, the expense ratio for that ETF turns out to be 0.2%. Expense ratio is significantly lower in case of exchange traded funds.

Expense Ratio - SEBI Limit

The securities market regulator, Securities and Exchange Board of India (SEBI), has, in the interest of investors, restricted the mutual fund houses to cap the expense ratio. Based on the value of assets managed by the fund, the limit on expense ratio is decided. The following table lists down various limitations regarding the same.

In nutshell

• Expense ratio is a measure by which you can calculate how much percentage of the investment value goes into managing the funds.

• It forms a good basis to decide whether the mutual fund is suitable as per your requirements or not since you can easily calculate net return after subtracting the expense ratio from the gross returns.

• Expense ratio comprises all the costs incurred to manage the fund such as fund manager’s fees, administration expenses, advertising expenses, exit load, etc.

• Expense ratio on exchange traded funds is much lower than the expense ratio on actively managed mutual funds.

• SEBI has set out rules and regulations to control the maximum amount of expense ratio a mutual fund company can charge to protect the interest of investors.