Expense Ratio - Definition, importance and types of expense ratio

When you invest in mutual funds, a professional team of experts manages your money. This management incurs costs in the form of operational expenses, which include allocation charges, advertising costs, etc. The mutual fund company recovers these expenses from the investors, in the form of expense ratio, within the limits prescribed by SEBI.

What is expense ratio in a mutual fund?

Simply put, the expense ratio is a fee you pay the mutual fund company to manage your investments. It differs across funds and is calculated as a percentage of daily investment value. This ratio, expressed in percentage, is mentioned in the mutual fund factsheet. The expense ratio lowers your actual returns by a small amount.

Essential components of a mutual fund’s expense ratio

The three crucial components of a mutual fund’s expense ratio are:

• Management fees

Every mutual fund has particular objectives. The fund house assigns a fund manager, who with a team of research analysts, works to meet these objectives. A mutual fund's expense ratio comprises the fund manager's compensation. Management fees are high for actively managed funds and lower for passive funds.

• Marketing fees

Every mutual fund house incurs costs related to marketing. These costs include creating awareness about the schemes and getting them distributed through mutual fund distributors (MFDs). They’re covered in the fund's expense ratio.

• Legal fees

Mutual funds need to comply with SEBI's regulations. For this, they constantly need legal intervention and an audit of their processes. Costs on audits, registration, and legal checks are a part of a mutual fund's expense ratio.

Mutual funds with low expense ratio

Here are some mutual funds with low expense ratios as of March 21, 2024.The expense ratios mentioned are for regular plans.

Significance of expense ratio

As an investor, the expense ratio of mutual funds plays a critical role in investments. A high expense ratio affects a fund’s returns and lowers net profit. At the same time, you benefit from fund management expertise in the case of active funds. On the other hand,mutual funds having lower expense ratios make smaller dents in the total returns, though most of these may be passive funds. Also, funds with higher expense ratios have lower NAVs and vice versa.

Also, it’s a common misconception that mutual funds with higher expense ratios tend to perform better than funds with lower ratios. However, it’s not always the case. In some instances, funds with lower expense ratios may have performed better than higher ones.

In conclusion

A mutual fund’s expense ratio is one of the critical metrics affecting your returns. While it’s essential to look closely at it before investing in a fund, it’s not the only criteria to consider. You must closely examine the fund’s objectives and ensure they align with your goals.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. Investors should conduct their own research and consult with financial professionals before making any investment decisions.