What is expense ratio in Mutual Funds?

Mutual Funds | admin | September 1, 2010 at 7:48 am

It is a charge paid by an investor to an asset management company for managing his money. It is an ongoing expense and charged as a percentage of net assets of the fund. SEBI regulations permit equity funds to charge a maximum of 2.5% as expense ratio, while in the case of debt funds, the maximum is 2.25%.

On an average, most equity funds have a expense ratio between 1.5% and 2%. In Expense Ratio in Mutual Fund case of index funds, it could be lower, in the range of 1-1.5%. The expense ratio is disclosed by a fund house once every six months, ie, every March and September.

What are the constituents of expense ratio?

1) Management fee — CEOs, fund managers, and sales and distribution personnel in a fund house are well qualified and bring with them much experience of the financial markets. While the sales and distribution team is responsible for bringing in money, good performance from the fund management team helps retain it. Being a people-intensive business, fund houses pay higher salaries and fat bonuses for attracting and retaining the best talent.

2) Administrative costs — These include expenses incurred for custodian charges, legal and audit fees, marketing and selling expenses, despatch of statement and other miscellaneous charges.

3) Trail fee is the commission that a distributor gets from the fund house till the money is invested with the fund house. It is usually paid on a quarterly basis and is generally 0.5% of the asset value.

How does expense ratio impact investors?

Put simply, expense ratio for an investor is the cost he pays towards the services he avails of from mutual funds. Expense ratio decides the returns of schemes. It is more than important in debt schemes where the rate of return is not high.

Especially, when the average debt funds deliver returns to the extent of 8-10% per annum, a 50-100 basis points difference in expense ratios of schemes could make a huge difference. This is more important in a rising interest rate scenario where lower the expense, greater the benefits for investors as low expense ratios boost the returns available for investors.

In case of equity mutual funds, as we have seen rising markets for some time now, expense ratio may not be an important factor to consider for investors. However, it must be noted that as markets mature and alpha — outperformance (of the fund) over the index — goes down, it becomes imperative to pay heed to expenses. Investors prefer index over equity funds as markets get depth.

For index fund investors, expenses matters the most. The performance of an index fund depends on tracking error and expenses ratio. Lower tracking error and expense ratio ensure that index funds meet the objective of offering returns in sync with the underlying index.

A look at all this makes one believe that the expense ratio is an important factor when you chose a fund. But beware, it is not the only factor when you chose a fund to invest your hard-earned money.

Source: Economic Times