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The Complete Guide to Expense Ratios in Mutual Funds

The Complete Guide to Expense Ratios in Mutual Funds

Mutual Funds in India have grown by leaps and bounds over the past few years. Investors have enjoyed good returns in what is one of the longest bull runs in the market since the 2008 crash. Most Mutual Fund houses have made record profits and the big ones have grown bigger. Some have even gone IPO and listed in the bourses, making the fund managers and employees very rich in the process.

But what about the investor? Is s/he getting a good bargain as the fund houses and distributors make merry? How do they actually make money? We understand more in this post.
1. What is the expense ratio of a mutual fund?
2. Why should you consider it before investing?
3. What goes into a mutual fund expense ratio?
4. How is the expense ratio calculated (deducted)
5. Should the expense ratio be the sole deciding factor?
6. Are Distributor Commissions Part of Mutual Fund Expense Ratio?
7. Are Indian Mutual Fund Expense ratios high?
8. Conclusion & Important Takeaways for the Investor

1.What is the expense ratio of a mutual fund?

An Expense ratio is a charge that a mutual fund collects from its investors. This is how they recover their costs and make profits. The expense ratio reflects in the daily NAV calculated and published by the fund house.

They vary by fund category with equity funds being more expensive than liquid funds. Any fund that requires more ‘expertise’ and ‘marketing’ will usually have a higher expense ration. Thankfully, in the interest of the investors, SEBI (the market regulator) has capped limits on them.

There is now a lot of discussion on how the expense ratio limits were set by SEBI when the industry was nascent and have become ‘archaic’ leading to the Mutual Funds making a lot of money, perhaps at the ‘expense’ of the investor. Now with the industry touching 25 lakh crores, these need to be revised.

2.Why should you consider it before investing?

An Expense ratio is very important for an investor because it affects the net returns. While they may appear small, over time say 20 years, they can run into lakhs of rupees. 

How? Let’s take an example. A 2.5% expense ratio over 20 years means that your initial investment of 10,000 earning 15% returns p.a. before expenses become Rs. 98 639 vs. Rs. 1,63,655. That’s a whopping one-third of the corpus.

Hence it makes sense to choose fund classes and funds that are lower in expense ratio and meeting the investment objectives of the investor. Direct plan mutual funds usually have no distributor commission paid and hence have a lower expense ratio by up to 1.5% or 150 basis points. Over the long term, this could mean up to 40% more in the final corpus.

3.What goes into a mutual fund expense ratio?

The Total Expense Ratio or (TER) at a fund level, covers most of the Fund House’s costs. These are all recovered from the investor. The following ‘items’ are part of the expense ratio:

  • Fund management fee
  • Transaction costs
  • Investor communication costs
  • Custodian fees
  • Registrar & Transfer Agent fee
  • Fee for platforms like MFU, BSE StAR
  • Marketing and Advertising costs
  • Auditor, Legal, etc amortized for the fund
  • Service tax on fund management charges
  • Distributor commissions

There are two more ‘interesting items’ here:

  • B30 charges: This is allowed by the regulator to incentivize fund houses to ‘sell more’ in the cities beyond the Top 30. So if a fund house is able to penetrate the tier2/3 cities, it is allowed to charge more.
  • Exit load charges: These are compensation for any premature exits by investors.

4.How is the expense ratio calculated (deducted)

Let us take an example to illustrate the calculation of the expense ratio of a mutual fund scheme.

  • You invest Rs 100,000, obtain returns of 12%, expense ratio of 2.5%
  • Returns after one year are Rs 1200.
  • Expenses on Rs 112,000 value = Rs 2,800
YearBeginning BalanceReturnsExpensesEnding Balance
  • Total Expenses (not considering the time value of money): Rs 3,96,193
  • Expenses as % of Final Value: 28%

5.Should the expense ratio be the sole deciding factor?

While the expense ratio is an important factor, it is not the only factor.

The risk-return equation matters across fund categories. For example, Liquid funds have lower expense ratio but also give lower returns whereas equity funds have higher expense ratio but in the long term give much higher returns. Here since most good funds give returns in a similar range, the expense ratio doe smatter.

Within a fund category, this matters too. For funds that offer higher returns, such as equity funds, this factor becomes more important. One must look at the consistency of returns and fund pedigree, process maturity. If these are superior and the fund does much better than benchmark consistently, then it makes sense to give greater allowance for a higher expense ratio. The net returns from the better fund may be much higher even with say a 50 basis point or 0.5% extra expense ratio.

However if a fund consistently shows a high expense ratio, and yet the returns are not great, ie consistently below the benchmark, then one should exit out of the fund.

This is because a consistent gap, say 50 basis point difference in the expense ratio of two identical mutual fund schemes in the same category can impact the growth of your investments.

  • Assuming Fund A and B are identical, both give 15% gross return but Fund A has a higher expense ratio of 0.5% then Fund B will give a higher corpus of about 8%.
  • A higher expense ration will lead to a higher difference in compounded performance.

6.Are Distributor Commissions Part of Mutual Fund Expense Ratio?

Let us dwell on the distributor commission a bit here. Typically, a direct plan has an expense ratio of around 1%, while regular plans cost 2.5% per year. The difference is about 1.5%. This may appear a small difference but could decide whether you holiday in New Delhi or New York or retire at 45 or 65. Over time, the difference in the expense ratio would add up significantly, thanks to the power of compounding. For example, a SIP of just Rs. 5,000 a month in a direct plan, over 25 years, would yield an additional Rs. 28 lakh over a regular plan.

Therefore, over the long term, regular plans eat into 40% of your wealth. The simple decision to ‘let the agent fill the form’ could end up costing you big over time!

Isn’t the commission expense a one-time thing?

No, the commissions are earned, not just the day you make your investment but for as long as your money is in the scheme. Shocked? This is known as trail commission.

Agents keep earning a commission at varying rates for as long as you’re invested in a scheme. So if you have a SIP going for the past 10 years, you’ve been paying your agent for each day of the past 10 years. Even if you haven’t met or spoken to the agent, he/she is still receiving payment. This is how may agents, despite doing largely clerical work, seem to have it made!

It is said that trail commission is like pension for the distributor. The question is if you are also getting a pension income.

7.Are Indian Mutual Fund Expense ratios high?

Though mutual fund expense ratios have somewhat come down since 2012, they need to come down faster as the industry has grown FOUR times since 2012. And globally they are among the highest!

Since 2012, the regulator SEBI in order to drive MF expansion made some changes in the expense ratio norms. These can be summarised as below.

Service Tax as an additional charge (now called GST)

The GST is charged only on the fund management charge and not on the other line items. This favors the AMC selectively.

The TER is Fungible

This means the fund house can increase fund management charge (the core expense) and make a fatter profit by becoming more efficient in other matters or paying distributors lesser. They would be got for the max TER allowed in a view to make a larger profit

Exit Load Charge

It allowed an additional charge of 20 basis points (of AUM) in lieu of an exit load, but the compensation was 5x to 7x what they actually incurred. Though this has come down to 5 bps it is still a drag.

Market Expansion ‘Charge’

SEBI allowed expenses of 30 basis points for business growth beyond the top 30 cities. This means investors are paying for the AMC’s growth!

All of this means that an equity mutual fund can now charge a maximum of 3.3 percent compared to 2.5 percent earlier. In the bargain the investor has suffered. In many countries, the fund management costs are about 50 bps to 75 bps whereas in India they are twice. The above points illustrate that there has been scope for enough padding.

8.Conclusion & Important Takeaways for the Investor

  • Direct plan mutual funds have a lesser expense ratio and with the help of a SEBI Registered Investment Advisor can give much better results.
  • Schemes that involve deeper expertise and cherry-picking, such as sectoral or thematic funds may carry a higher expense ratio. An investor ought to match her risk profile (or consult an advisor) to see if it is worth taking the additional risk and incurring higher expense ratio in these funds.
  • Schemes that are usually marketed heavily (eg: close-ended funds or New Fund Offerings) will pass on the cost to the investor in the form of a higher expense ratio. An investor needs to understand this carefully before investing in them.
  • Exit loads are not considered part of the Total Expense Ratio, but still, do affect an investor. From an investor point of view, ‘expense’ must include the cost of buying, cost of staying (traditional TER) and cost of exiting. AMFI data shows that 51% (ie a ‘majority’ or more than half) investors exit before completing 1 year in an equity fund.