How Does Expense Ratio Impacts Fund's Performance?

Many factors impact the returns you generate on your mutual fund investments. The expense ratio of a fund is one such factor. Most financial advisors recommend looking at the expense ratio of a mutual fund while deciding to invest in it. Let’s learn the expense ratio, how it is calculated, and how it impacts the fund’s performance.

What is the expense ratio of a mutual fund?

The expense ratio of a mutual fund refers to the percentage of its average Net Asset Value (NAV) that is payable to the Asset Management Company (AMC) as fund maintenance charges. Every AMC charges an expense ratio to their customers to cover the operating expenses for maintaining the mutual funds they offer.

Typically, a fund’s expense ratio includes various costs, such as administrative charges, distribution and marketing fees, record-keeping fees, and management charges, among others.

On 18th September 2018, the Securities and Exchange Board of India (SEBI) laid down the guidelines to regulate the maximum expense ratio AMCs can charge from their customers. The table below depicts the maximum Total Expense Ratio (TER) allowed by the SEBI for various types of mutual funds:

AUM (In Rs. Crores)TER in % (Equity Funds)TER in % (Debt Funds)
0-5002.252
500-75021.75
750-2,0001.751.5
2,000-5,0001.61.35
5,000-10,0001.51.25
10,000-50,000It starts at 1.5 and reduces by 0.05 for every increase of Rs. 5,000 crores in AUMIt starts at 1.25 and reduces by 0.05 for every increase of Rs. 5,000 crores in AUM
Above 50,0001.050.80

What factors determine the Expense Ratio of a fund?

As mentioned, the expense ratio of a mutual fund scheme constitutes various charges incurred by the AMC for maintaining the underlying assets. Three major components are used to derive the expense ratio of a fund.

Management fees

The management fee is the compensation given to the fund manager for managing a mutual fund. They must formulate investment strategies to dictate the fund’s revenue and returns. On average, AMCs pay 0.50 to 1 per cent of the total Assets Under Management (AUM) to their fund managers.

Administrative costs

These are the costs incurred by the AMC for managing a mutual fund. They include custodian charges, registrar fees, advertising and marketing expenses, record keeping, and service-related costs. These charges can vary significantly from one mutual fund to another.

Distribution fees

Some fund houses pay distribution or commission fees to distributors, brokers, and investment advisors for promoting their mutual funds. They charge this fee from their customers by adding it to the total expense ratio of their funds.

The expense ratio is calculated by dividing the total expenses incurred by the AMC under the components mentioned above by the total AUM of a mutual fund. For example, if an AMC incurs Rs. 1.5 lakh for managing a mutual fund with an AUM of Rs. 1 crore, the expense ratio would be 1.5 divided by one crore, i.e., 1.5%.

How does Expense Ratio impact fund’s performance?

As you can see, a fund’s expense ratio indicates how much the AMC charges from their customers for managing the funds allotted to them. For example, if you invest Rs. 50,000 in a mutual fund with an expense ratio of 2%, means that 2% of your investment, i.e., Rs. 1,000 will go towards the AMC for the management of funds.

Therefore, a mutual fund with a lower expense ratio means more profitability for the customers and vice-versa. However, this expense ratio is not deducted directly from the returns generated by a fund. Instead, it is removed from its NAV while allotting fund units to the investor.

So, the expense ratio of a mutual fund does not impact its performance directly as it is based on the factors such as market fluctuations and the fund manager’s capabilities. However, it brings down the overall returns generated by the scheme.

For example, suppose you have invested a certain amount in a mutual fund with an expense ratio of 2%. Now, if the fund generates 12% returns in, say, one year, the actual returns that you will get on your investment would be 12 minus 2, i.e., 10%.

Conclusion

The expense ratio of a mutual fund is an essential factor. It tells you about the percentage of your investment that you need to pay to the AMC every year for managing your funds. A higher expense ratio can significantly lower the returns generated by a mutual fund in the long run.

Having said that, the expense ratio should not be your sole criteria while selecting a mutual fund for investment. You should give weightage to some other factors as well, such as the fund manager’s track record and experience, past performance of the fund, and market insights about the underlying assets.