Over the past few years, mutual funds have emerged as a prudent choice for retail investors seeking a diversified and managed approach for growing their wealth. As one ventures into mutual funds, the term ‘expense ratio’ surfaces as a vital concept that demands understanding. In simple terms, an expense ratio reflects the costs incurred by a mutual fund in administering its operations and managing its portfolio.
Expense ratio formula
The expense ratio is computed using a straightforward formula –
Expense ratio = Total expenses/average AUM (asset under management)
Total expenses are the cost incurred by the asset management company (AMC) such as fund manager’s fee, distribution cost, marketing expense, audit cost, etc.
Average AUM is the overall value of all retail investors’ money invested in that fund.
Example of expense ratio computation
Let’s assume a hypothetical equity mutual fund scheme with an AUM of Rs 1,200 crore, and the expenses it incurs for various operational costs sum to Rs 18 crore.
Using these figures, the expense ratio calculation would be as follows –
Expense ratio = Rs 18 crore / Rs 1,200 crore = 1.50 per cent
This infers that in a year, each retail investor must pay an expense ratio equaling 1.50 per cent to the AMC. Note that this percentage would be charged on a daily basis for the entire investment duration for managing the mutual fund scheme.
What are the major components of an expense ratio?
The expense ratio consists of several components that encompass the operational costs of the mutual fund. These components include –
Distribution costs
These are associated with the marketing and distribution of the mutual fund, often involving broker commissions and marketing expenses.
Administrative costs
These cover day-to-day operational expenses, including record-keeping, legal and compliance fees, and customer service.
Management fees
Management fees are paid to the mutual fund’s managers for making investment decisions and managing the investment portfolio.
Other expenses
This includes additional costs such as audit fees, custodian fees, and other miscellaneous expenses.
Impact of expense ratio on mutual funds
The expense ratio has a considerable impact on a mutual fund’s performance. While it may appear insignificant initially, over time, even slight differences in expense ratios can significantly eat into an investor’s returns. Simply put, higher expense ratios can erode the overall returns earned by investors, particularly in the long term. This emphasises the importance of selecting offline or online mutual funds with lower expense ratios, especially when considering an SIP (systematic investment plan). This is one of the popular mutual fund investment plans to generate wealth through systematic investments of small amounts of as low as Rs 100 on a periodic basis, usually monthly.
Conclusion
The expense ratio is a fundamental metric, expressed as a percentage that encapsulates the expenses associated with managing a mutual fund and ultimately influencing the returns investors reap. As individuals increasingly turn to SIP mutual funds for their financial futures, grasping the nuances of the expense ratio becomes paramount. By making informed decisions and selecting funds with lower expense ratios, investors can align their portfolios with their long-term financial goals and earn higher returns on their market investment.
