Expense ratio of a mutual fund scheme refers to the annual fee charged by a mutual fund house to the investors for the management of the scheme. It is calculated by dividing a mutual fund scheme’s total expenses by the value of assets under its management (AUM).
While managing a scheme, a fund house incurs expenses such as administrative cost, marketing cost, promotion cost, distribution cost, compliance costs, shareholder service cost, etc., which get reflected in the scheme’s expense ratio.
SEBI Regulations on Expense Ratio
As per the capital market regulator, SEBI (Securities and Exchange Board of India), fund houses can charge Total Expense Ratio (TER), subject to the following maximum limits:
|Asset Under Management (crores)||TER for equity-oriented schemes (%)||TER for other schemes excluding Index Funds, ETFs and Fund of Funds (%)|
|Rs. 10,000-50,000||For every increase of 5,000 crore in AUM TER reduces by 0.05%||For every increase of 5,000 crore in AUM TER reduces by 0.05%|
|> Rs. 50,000||1.05||0.80|
Expense Ratio is inversely related to the AUM of the fund. When the value of a funds’ assets is small, the expense ratio is higher such that the management meets the fund expenses from a smaller asset base. Whereas, when the asset value of a fund is huge, the expense ratio is comparatively lower as the expenses get distributed across a wider asset base.
However, SEBI allows fund houses an extra of 30 basis points (0.30%) in expense ratio over and above the mentioned maximum limits for selling in beyond top 30 cities, only if 30% or more of new inflows come from beyond the top 30 cities. This is done to widen the penetration of the mutual funds in tier 2 and tier 3 cities.
Fund houses are also allowed to charge 5 basis points (0.05%) of AUM over and above the maximum expense ratio limits in lieu of an exit fee, wherein exit load is levied or is applicable. However, AMCs are not allowed to charge the expense ratio in lieu of exit load for close-ended schemes.
Expense Ratio of Index Funds, ETFs, and Fund of Funds (FoFs)
Index Fund: An Index Fund is a mutual fund which invests in a market index such as the Nifty 50 or the Sensex. The fund invests in index stocks, in the weights in which they are present in the index. It thus seeks to replicate the performance of an index. This does not require a high level of active management of the fund and hence, the expense ratio of index funds tends to be low.
Exchange Traded Funds (ETFs): ETF is a type of fund which passively invests in stocks, bonds or commodities, usually tracking an Index like the Nifty 50 or the Nasdaq 100 (for instance, Motilal Oswal Nasdaq 100). An ETF is traded on stock exchanges just like stocks. One must have a Demat and trading account to invest in it. In case of an ordinary mutual fund, you can directly buy units from the fund house, without going to a stock exchange. An ETF is a passive instrument (not actively managed) and hence, tends to feature a significantly lower expense ratio as compared to mutual funds.
Fund of Funds (FoFs): A Fund-of-funds (FoF) is a mutual fund which invests in other mutual funds. In India, FoFs are typically mutual funds investing in overseas mutual funds, which in turn invest in foreign stocks (for instance, Franklin India Feeder Franklin US Opportunities Fund) or FoFs investing in gold ETFs (for instance Reliance Gold Savings Fund). The expense ratio of FoFs is relatively higher than what an investor would incur by directly investing in the underlying mutual fund.
Expense Ratio of Direct vs Regular Mutual Fund Schemes
Mutual fund schemes come in two plans- direct plan and regular plan. The only difference between the two is that in case of a regular plan, your asset management company (AMC) or mutual fund house does pay a commission to a broker or agent as distribution expenses or transaction fee out of your investment, whereas in case of a direct plan, no such commission is paid.
Thus, direct mutual fund plans have a lower expense ratio than that of the regular mutual fund schemes.
Expense Ratio Calculator
You do not need a calculator to know the expense ratio of a mutual fund scheme. Every fund house publishes the expense ratios for all its mutual fund schemes in its factsheets. These factsheets are updated every month and are available on the websites of AMCs.
How to Calculate Mutual Funds Expense Ratio?
There are many ratios that you can use to evaluate a mutual fund. However, not all of them are equally useful. According to experts, the below mentioned 5 basic ratios may be used to analyze any mutual fund. However, If there are still any doubts about your fund selection, you always check with the additional ratios.
Standard Deviation is the most widely used measure of calculating the risk involved in a mutual fund. Standard Deviation is basically the square root of variance.
Standard Deviation is given by the following formula:
In this case, x is each individual value (say, monthly return). X (bar) is the average of the values (such as the monthly return average). N would be the number of months (60, for example, if we are looking at a 5 year period).
A high standard deviation indicates the involvement of higher risk in the fund and vice versa. For instance, the standard deviation of HDFC Equity Fund is 18.49% while the standard deviation of HDFC Hybrid Equity Fund is 11.41%. The standard deviation of HDFC Liquid Fund is just 0.21%. In a normal statistical distribution, approximately 95% of observations fall within 2 standard deviations. This means that you would expect returns of HDFC Liquid Fund to give returns within 0.42% of its average value of 6.89%, with a 95% probability. However, this only holds true if the mutual fund returns follow a standard deviation.
This ratio refers to the percentage of a mutual fund’s assets which have been bought/sold in the previous year. For example, a turnover ratio of 50% means that a Mutual Fund has bought/sold stocks equal to 50% of its average assets.
A high turnover ratio can mean that the fund manager is frequently changing his strategies and incurring high transaction costs (buying and selling transactions involve brokerage and other costs). Thus, a high turnover ratio is usually viewed as a negative factor.
Alpha or Jensen’s Alpha is the degree with which a mutual fund is outperforming its benchmark adjusted to its risk level. For example, if the fund is benchmarked to the Nifty 50 which has given 10% returns and the fund delivers a return of 12%, it would have an alpha of 2%.
A high alpha implies that the fund is outperforming. On the other hand, a low or negative alpha indicates the poor performance of a fund.
This ratio gives the sensitivity of the mutual fund to the market. The higher the beta, the more sensitive the fund is. For example, a beta of 2 indicates that for every 1% move in the market, the fund’s NAV will move by 2% on average.
A high beta fund can imply both higher risk and higher return (and vice versa for a low beta fund).
This ratio incorporates both risks and returns. It gives you an idea of the return delivered by a fund compared to the risk it is dealing with. For example, some funds may deliver higher returns only by taking higher risk. Such returns should be viewed with more skepticism than the funds which give high returns while taking a low level of risk. Mathematically, the Sharpe ratio divides the outperformance generated by a fund compared to the risk-free rate with the volatility of the fund.
A high Sharpe ratio indicates high return for a given risk level. This is a highly desirable quality in a fund and hence, mutual fund schemes with higher sharpe ratios should be preferred.