Why does a mutual fund’s expense ratio matters?

When you invest directly in securities like stocks, the research is yours, you make the decision, and you stay vigil and informed. But when you invest in the same securities through a mutual fund, a fund manager will research and make decisions for you and they keep the portfolio of the fund relevant at all times. But how do fund houses compensate these fund managers for their expertise? From you! Mutual funds charge you a small percentage of your capital as a fee for the management of the mutual fund and this fee is called an expense ratio. Let’s take a deeper look at expense ratios and see how they can affect your mutual fund investment

What is an expense ratio?

As said above, the fund houses charge this management fee from you. It is usually a percentage of your total investment value. This amount is decided according to the Securities and Exchanges Board of India’s (SEBI) regulations. The below table shows expense ratio limits as per SEBI’s rule.

Assets under management (In Rs. Crore)Total equity ratio for equity fundsTotal equity ratio for debt funds
0 to 5002.25%2%
500 – 7502%1.75%
750 – 20001.75%1.5%
2000 – 50001.6%1.35%
5000 – 10,0001.5%1.25%
10,000 – 50,000          Starts at 1.5%, and goes down by 0.05% for every rise of Rs 5000 crore in AUMStarts at 1.25%, and goes down by 0.05% for every rise of Rs 5000 crore in AUM
More than 50,0001.05%0.08%

Components of an expense ratio 

Management fees – Managing a mutual fund, where money from a number of investors is at play, is not easy. It requires excellent expertise, and the expertise should be paid well also. This is why fund houses charge management fees through the expense ratio.

Administrative costs – Running a mutual fund comes with its expenses. Fund houses have to keep records, hire customer care executives and marketers, etc. For the fund houses to meet such expenses and pay the staff, an administrative fee is charged through the expense ratio.

12-1b distribution fees – 12-1b is an annual fee charged from the investors for the distribution and marketing of mutual funds. Here, if the fund is subscribed by more people, the expense ratio could come down and it will be beneficial for the shareholders as well.

Brokerage fees – Mutual funds are managed in two ways. Direct mutual funds are managed by fund houses themselves while in the case of regular mutual funds, a broker is needed for sales and distribution. Hence, a brokerage fee is added to the expense ratio to compensate the broker in regular mutual funds.

Significance of expense ratio in mutual funds

Keeping a track of expense ratios makes sure that you make the best out of your investment. Since the expense ratio is charged from your profit, you can learn how much your fund is really making and what part of it is being taken by the fund house. If you feel like your fund is charging you more, you could compare with other similar funds and even switch to one of them if they offer a better expense ratio. A higher expense ratio could hamper your earnings in long term. 

Understanding the expense ratio is important in understanding your profit potential with each mutual fund. Information about expense ratios is available through all major broker and fund house websites. You can also use resources from the Association of Mutual Fund in India (AMFI) website for this. Include expense ratio in your calculations and make sure you know exactly what you will earn!