6 reasons why expense ratio in mutual fund is important to investors

What does a mutual fund’s expenditure ratio mean?

This expense ratio in mutual fund expresses the expense of operating a fund on a per-unit basis. This ratio is calculated by dividing the fund’s total costs by its assets under management (AUM).

The expenditure ratio includes a variety of fees paid by the fund house. For instance, there is a fund management staff that monitors the equities and debt markets and the portfolio firms. Additionally, the fund house incurs charges such as registrar, custodian, legal, and audit fees and marketing and distribution fees for its products.

These expenses are collected daily from the fund scheme’s unitholders, and the fund scheme’s daily net asset values (NAVs) are published after subtracting them.

Why is the expenditure ratio different between the regular and direct plans?

In a direct plan, you purchase the mutual fund directly from the fund house. In contrast, you are buying the mutual fund via an intermediary such as an adviser or distributor in a regular plan.

In this conventional plan, the fund house pays a commission to the intermediary, subsequently recouped via the plan’s cost ratio. As a result, the expense ratio in mutual fund for a standard method is larger.

The importance of expense ratio in mutual funds to investors

After going through a beginner’s guide to expenditure ratios, it is now time to delve into their significance from the point of view of the investor.

  1. The cost ratio represents the yearly percentage fee charged by the fund to handle your assets in the plan. If you put ‘10,000 in a fund with a 2% fee ratio, you will pay ‘200.

Expressed, if a fund yields 15% and has a 2% cost ratio, you will get a return of 13%. A smaller ratio indicates more profitability, whereas a larger ratio indicates less profitability.

  1. The cost ratio of a mutual fund is important to investors since fund operational and management fees may significantly influence net profitability. The expense ratio in mutual fund is derived by dividing the entire dollar value of the fund’s assets by the total amount of fund fees paid to investors in the fund, including management fees and operational expenditures.
  1. Mutual fund expense ratios vary significantly. Index funds have lower expense ratios than actively managed portfolio funds, averaging 0.06 percent in 2020. In 2020, actively managed funds’ cost ratios averaged 0.71 percent; however certain funds had substantially higher expense ratios.
  1. Most investors are unaware of the enormous impact of a seemingly slight percentage variation in mutual fund cost ratios. Still, an example reveals that even a minor difference greatly influences net investment earnings.
  1. Consider two mutual funds that earn an average annual rate of return of 5% on average, with one fund charging 1% and the other charging 2% in fees. While the difference of a single percentage point may not seem significant to most investors, the cost is calculated on assets under management, not profit earned.
  1. Assume two investors begin the year with $100,000 each in 1% and 2% expense ratio in mutual fund, respectively, and each fund generates a 5% return on investment before fees are deducted.

The investor who pays 1% in fees forfeits $1,000 (1 percent of $100,000) of his $5,000 profit. The investor who pays 2% in fees loses $2,000 of his $5,000 gain. Thus, a 1% difference in expenditure ratios results in a 10% difference in net earnings.

What is the maximum expense ratio that the market regulator will allow?

SEBI has established a limit for open-ended equity-oriented mutual fund expense ratio schemes based on their AUM. It is 2.25 percent for the first ‘500 crore; 2% for the next ‘500 crore; 1.75 percent for the next ‘750 crore; 1.6 percent for the next ‘2,000 crore; 1.5 percent for the next ‘5,000 crore; 0.05 percent for each additional ‘5,000 crore; and 1.05 percent for AUM beyond ‘50,000 crore. A fund of funds investing in liquid, index, and exchange-traded funds (ETFs) may charge a maximum of 1%.