Expense ratio of a mutual fund scheme refers to the annual fee charged by the mutual fund house to the investors of the scheme for the management of the scheme.
Expense Ratio Formula
Fund’s Total Expenses X 100
Expense Ratio (%) = Asset Under Management (AUM)
Expense Ratio is calculated by dividing the fund’s total expenses by its assets under management. The fund’s total expenses include costs such as administrative cost, marketing cost, promotion cost, distribution cost, compliance cost, shareholder service cost, etc. For instance, if the AUM of a fund is Rs. 1 crore and its total expenses stand st Rs. 1.5 lakh, then the expense ratio of the fund is:
Expense Ratio = (1,50,000/1,00,00,000)* 100 = 1.5%.
Thus, if Mr. X invests Rs. 10 lakh in this fund, he will be bearing expenses of 1.5% of his total investment in the fund, i.e. Rs. 15,000.
SEBI Regulations for Expense Ratio
As per the Securities and Exchange Board of India (SEBI), the 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 to enable the management to meet 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 note that the total expense ratio cap, as laid down by SEBI also falls with increasing AUM.
However, SEBI allows fund houses an extra 30 basis points (0.30%) in expense ratio over and above the above mentioned maximum limits for selling in beyond top 30 cities 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 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 similar to stocks and you need 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 your broker as distribution expenses or transaction fee out of your investment, whereas in case of a direct plan, no such commission is paid. Instead, in case of direct plans the commission is added to your investment balance, thereby reducing the expense ratio of your mutual fund scheme and increasing your return over the long-term.
Thus, direct mutual fund plans have a lower expense ratio that 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.