Explanation on Mutual Funds Expense Ratio

Introduction

Expense Ratio states how much you pay a fund in percentage terms every year to manage your money. It is an efficiency ratio that measures the management expenses as a of percentage total funds invested in a mutual fund.

Expense Ratio : Meaning

  • Mutual Funds can be costly to create, manage and maintain. A profesional fund manager must actively manage the invested assets and research new investments. Thus, the fund manager must ensure that the fund is investing in accordance with its goals.
  • To manage your money, a mutual fund house/AMC incurs some expenses such as fund management fee, administrative fees, registrar fees, auditor fees, advertising expenses and other asset-based costs incurred by the fund. To manage these expenses, fund house charges a fee for their services which is called Expense Ratio.
  • Expense ratio does not include Portfolio transaction fees or brokerage costs, as well as initial or deferred sales charges.
  • Potential and current investors use expense ratio to see how efficiently the fund is being managed. A higher ratio indicates that more expenses are incurred to manage a set amount of assets. A lower ratio indicates that less are expenses are needed to measure the same amount of assets. In other words, management is doing a more efficient job at operating the fund.
Expense Ratio

Formula

Lets see how to calculate the Expense Ratio –

  • We can calculate by dividing the fund’s operating expenses by the average value of the fund’s assets.
  • Expense Ratio = [ Operating Expenses ÷ Average Value of Fund Assets ]
  • As se can see in the above equation, only the operating expenses are used. Loads and sales commissions are not included. Because these costs are related to running the fund on a daily basis.
  • Front-end load and Back-end load are the one time costs that are incurred only when an investor invests in the fund or sells his/her assets in the fund.

Types of Expense ratio

  1. There are two types of plan available for investors in mutual fund- Direct plan and Regular plan. Thus, there are two types of expense ratio with respect to these plans- regular and direct.
  2. In Regular plan we invest with help of intermediary like distributor, advisor, broker etc. They provide us recommendation for investment, track our portfolio from time to time and for this they charge fees from us.
  3. In Direct plan investor use his own experience and intelligence without any outsider help for managing his portfolio. That’s why he doesn’t need to pay any extra money.
  4. Thus, in Regular Plan, Expense ratio is higher as compare to Direct Plan.
Example :
  • We have seen that, Why in Regular Plan Expense ratio is higher as compare to Direct Plan? Here you can understand this with help of below graphs. Aditya Birla Sun Life Frontline Equity Fund’s direct expense ratio is between 0.8 to 1.6 but regular expense ratio is between 1.8 to 2.2 in last 5 years. For the detailed analysis of – ABSL Frontline Equity Fund, Refer – https://mfyadnya.in/
  • Normally we compare specific months yearly for last 5 years. But if in case for that specific month data is not available, then we used nearby month data for our comparison.
Expense Ratio of ABSL Frontline Equity Fund – Direct Plan & Regular Plan

SEBI LIMITS ON EXPENSE RATIO

SEBI has stipulated a maximum limit on these Expense ratios. Equity funds can charge maximum upto 2.5%, debt funds can charge max upto 2.25% & index funds can charge max upto 1.5% of average weekly net assets. Always remember, irrespective of whether a fund generates positive or negative returns expenses are always incurred.