What is a Good Expense Ratio for Mutual Funds?

Key Highlights

• The yearly fee mutual fund or exchange-traded fund holders pay to fund management is known as the expense ratio.
• Over the past few years, competition has caused expense ratios to drastically decline.
• Nowadays, an expenditure ratio greater than 1.5% is usually regarded as excessive. A suitable range for an actively managed portfolio's expense ratio is 0.5% to 0.75%.
• The percentage for passive or index funds is typically 0.2%, however, it occasionally drops to 0.02% or less.

What is the Expense Ratio?

The costs mutual fund firms charge to operate a mutual fund are represented by the expense ratio. It is given as a proportion of the total assets that are being managed. The size of the mutual fund under consideration affects the value of an expense ratio. A portion of the limited financial resources available to a fund must go towards efficient administration. This increases the relative value of the expenses compared to the total amount of accessible funds. When it comes to large-cap mutual funds, the amount designated for expenses is a smaller percentage of the total asset value. Consequently, there is an inverse relationship between mutual fund size and expenditure ratios.

The expenditure ratio formula, which is derived by dividing total expenses by the total assets of the funds, serves as a representation for this. Assuming unchanged total costs, the ratio decreases with increasing asset base and vice versa.

Components of the Expense Ratio

Here are the components that constitute a mutual fund scheme's expense ratio, computed by dividing the total expenses paid by the AMC by the AUM:

• Fund Manager's Fee: Compensation paid to the fund manager for managing the fund's portfolio and making investment decisions.
• Marketing and Distribution Charges: Expenses associated with marketing the mutual fund scheme and distributing it among investors, including commissions to distributors.
• Legal and Audit Fees: Costs related to legal compliance, regulatory filings, and audit expenses incurred by the mutual fund scheme.
• Operational Costs: Various administrative expenses, such as administrative staff salaries, office rent, utilities, and other operational overheads involved in managing the fund.
• Other Miscellaneous Expenses: Additional expenditures that contribute to running the mutual fund scheme, including printing and stationery costs, communication expenses, etc.

How Does the Expense Ratio Impact Fund Return?

Annual returns are impacted by expense ratios, which are subtracted from the total revenue of a mutual fund. Investors must carefully examine these ratios since greater ratios mean a larger percentage of returns are being subtracted.

Expense Ratio Implications

There is a widespread misperception that a mutual fund with a higher cost ratio is better managed and has a higher chance of making money. Low-cost mutual funds can also provide large returns if they are overseen by experienced managers who have accurate market analysis.

Conversely, mutual funds with a high cost ratio can be actively managed to provide higher returns or invested in businesses with a greater chance of making a profit. The increased costs incurred will be offset by a larger income earned.

Expense Ratio Limit by SEBI

The Securities and Exchange Board of India (SEBI) imposes limitations on asset management firms in India in order to safeguard investor interests and guarantee a significant flow of money to the capital market. For exchange-traded funds and index funds, the regulations are different. A maximum total expenditure ratio of 2% is applied to an initial asset base of Rs. 500 crore, and a ratio of 1.75% is applied to successive asset values of Rs. 250 crore.

Conclusion

Investors have to understand the mutual fund expense ratio in order to assess how charges affect their investments. Reduced deductions from investment returns are indicated by a lower expense ratio, which might result in better net returns for investors. Investors may make more informed judgements and ensure transparency by understanding these ratios and their ramifications, which can help maximise possible returns on investment.