Expense Ratio: The Cost of Investing | Why Savvy Investors Watch This | Smart Investing: Understand Your Expense Ratio | Definition, Significance, Formula, Example, Impact
What is an Expense Ratio in Mutual Funds and ETFs (Exchange Traded Funds)? | How does the Expense Ratio work?
Expense Ratio is also known as the “Gross Expense Ratio”. It is the annual cost of investing which is subjected to the size of the fund, duration and exit/maturity, generally larger fund base has lower expense ratio. It includes the portfolio management and administration fees, advertisement & marketing costs, distribution cost and other operating costs of the fund. Usually, all the AMCs and fund houses clearly mention the expense ratio with the particular mutual fund scheme on their official website and prospectus of the scheme.
Expense Ratio is associated with mutual funds and exchange traded funds (ETFs). But, the expense ratio and return generated by the ETFs and mutual funds may vary from each other. Generally, ETF is more cost saving way than mutual funds. Investors must consider every cost associated with the investment before making an investment, as it impacts the return. it is represented as a percentage form. Expense Ratio varies scheme to scheme and based on different brokerage firms. Some experts advise to avoid expense ratio more than 1%.
A small change in expense ratio, even 0.10% may significantly affect our investment. An investor, for instance, pays INR 50,000/- as an expense ratio of 0.5% on her/his investment of INR 1 Cr; but the same investor will pay extra amount of INR 10,000/- in case of 0.6% expense ratio instead of 0.5%. A small looking increase of 0.10% in expense ratio will cost extra INR 10,000/- to investor.
Expense Ratio by Abhishek Bansal | Image Source: Canva
When does expense ratio applicable
An investor doesn’t need to pay investment cost as an expense ratio separately. The expense ratio is an annual cost but it is deducted on daily basis from the investor’s investment by the AMCs.
The NAV (net asset value) of the fund appears on investors side after the deduction of expense ratio.
An expense ratio may seem a minutest or negligible expense but it is a fixed cost of investment. It doesn’t matter whether fund is performing good or not, to wit, no matter that fund is generating return or not, but a fixed cost as an expense ratio will be deducted by the AMCs. A higher expense ratio will greatly hurt our investment regardless of investment performance. A lower expense ratio can lead to higher return with better compounding.
For example – if a fund generates 18% return and its fixed cost as an expense ratio is 1.50% then investors will get actual 16.50% return.
Let’s assume another scenario, if market has been tensed due to several reasons over a period of a year, that’s why fund didn’t perform well and generates negative return of -4%; in this case our investment will be decrease by 4% as well as the cost of investment that is expense ratio.
That’s why, investors are advised to better understand the cost and future impacts of expense ratio and a careful comparison of it to maximize the long-term return before choosing a fund for investing.
How AMCs (Asset Management Companies) calculate the expense ratio | How is expense ratio calculated
Expense Ratio Formula
Generally, AMCs use following formula to calculate the expense ratio of a fund –
Expense Ratio % = [(Total Annual Expense of Fund X 100) ÷ Average Net Assets of Fund]
For Example – if a fund has total annual cost including all the operating and managing cost of INR 10 Cr and the average net asset value of the fund is INR 500 Cr, then according to aforementioned formula the expense ratio will be 2%, this means if we have invested a sum of INR 1 Cr in the above fund then we will pay INR 2 lakh as expense ratio.
A small percentage may seem negligible but here we can see in the above example that this small percentage turned into a handsome expense according to our investment amount. The bigger the investment amount, the bigger the effect of small percentage.
Furthermore, the cumulative effect over the time may affect long-term returns, as our investment grows, the cost of investment also increases.
Some Main Ingredients of Expense Ratio
Maintenance Cost – It includes exit fees, customer support, various overhead expenses etc. The maintenance cost of a fund is an important cost to operate smoothly.
Exit Load – Most AMCs (Asset Management Companies) or fund houses levies the exit load on the total invested amount for early withdrawal or before the pre-determined exit period to stop the investors from early withdrawal. This charge varies from AMC to AMC and fund to fund. In today’s era, charges for exit load can readily be known by the official website of the AMC/fund houses. Investors must consider the charges of exit load before making an investment in the mutual fund scheme, and investors should look into the charges of exit load before making an exit the scheme.
Brokerage – An additional burden is also added with expense ratio if mutual fund scheme is a “Regular Fund”, as AMCs hires a broker to process the portfolio transaction. The brokerage fee may be high if a fund follows aggressive or frequent trading strategies. A higher cost of brokerage fee will also affect ultimate return of the investment.
Management Fees – It is one of crucial components of an expense ratio, as it is charged to investors to pay fund manager/s to manage the fund. The management fees may vary fund to fund. Furthermore, the renumeration of fund managers depends on their expertise level, her/his track record, performance of fund under her/his management, fund size, futuristic strategies for investment growth and etc.
Expense Ratio: The Cost of Investing By Abhishek Bansal | Image Source: Canva
Impact of Expense Ratio on Return and A common misconception among investors for Expense Ratio | How does the expense ratio impact the return
A higher expense ratio may greatly impact on return, as AMCs first cut the proportion of the expense ratio from the total investment (including return), then distribute the remaining among investors, to wit, higher proportion will be subtracted as the expense ratio from the total investment (including return) for a higher expense ratio. That’s why, investors must consider and compare the future impact of expense ratio before investing.
There is no relation of expense ratio with return generated by that mutual fund scheme. A higher expense ratio isn’t a guarantee of higher return and a lower expense ratio scheme may also generate good return. The return generated by a mutual fund scheme depends and may impacted by some of many factors, such as – asset allocation by the fund managers, research-analysis and predictions by the fund managers, timely adjustments by the fund managers, skills and experience of fund managers, sector and industry concerns, geo-political issues, internal and other issues of those companies in which money has been invested, any unfavourable situation like pandemic, utilizing wrong and unlawful practices by the fund houses etc.
Expense ratio also depends on the way of managing the fund. An actively managed fund may have higher expense ratio than passive funds or passively managed funds such as – Index Fund, as the main aim of the fund managers with active funds is to beat the benchmark return, to wit, generate more returns than return generated by the benchmark. Actively managed funds include the specific investment strategies, more research and aggressive trading to beat the benchmark’s return.
On the other hand, the Index Funds or Passive Funds usually have lower expense ratio than active funds, as there is no aim to outperform the benchmark’s return. That’s why, passive funds don’t need of active management by the portfolio managers. The return generated by passive funds may be same or lower than that of benchmark.
Furthermore, two funds may offer a similar return in a percentage form, but their expense ratios will certainly impact actual return.
What is a good expense ratio
Investors should look mutual funds or exchange traded funds (ETFs) with lower expense ratios, as lower expense ratio means more amounts will be reinvested by the AMCs. But risk appetites and investment goals vary investors to investors, that’s why one fund may be ideal for an investor, but it may not be good for another investor. Some experts advise to choose fund with expense ratio less than or equal to 1. In simple words, expense ratio above 1 percent is considered high.
SEBI on expense ratio | SEBI limitations on expense ratio
The securities market regulator “SEBI (Securities and Exchange Board of India)” has determined some restrictions regarding expense ratio for AMCs to protect the investors interests. These restrictions are different for Index Funds and Exchange Traded Funds. Individuals may visit to SEBI’s Website to learn better about the limit and restrictions for mutual fund’s expense ratio determined by the regulator authority.
Total Expense Ratio (aka Net Expense Ratio)
In a competitive world, an AMC may offer a reimbursement or waivers for the expense ratio, and after this adjustment the expense ratio (= gross expense ratio) is called the “Net Expense Ratio”. The net expense ratio rewards with more than prior gross expense ratio.
Example: A mutual fund scheme has a gross expense ratio of 0.90 %, and a waiver of 0.15 % is offered by the AMC for a limited time period. Now, the net expense ratio is (0.90 – 0.15)% = 0.75 %. Mutual Fund investors should keep an eye on such updates released by the AMCs.1
Q. How expense ratio affects the NAV (Net Asset Value)?
Ans. The NAV (net asset value) of the fund appears on investors side after the deduction of expense ratio.
Q. What is TER and NER in mutual fund?
Ans. TER stands for Total Expense Ratio?
NER stands for Net Expense Ratio?
Q. What does a 1% expense ratio mean?
Ans. An investor will pay INR 1 as an expense ratio on an investment of INR 100.00
Q. How asset management companies calculate the expense ratio for a fund?
Ans. AMCs use the following formula to compute the expense ratio –
Expense Ratio % = [(Total Annual Expense of Fund X 100) ÷ Average Net Assets of Fund]
Q. How does an expense ratio work?
Ans. The expense ratio is an annual cost, but it is deducted on daily basis from the investor’s investment by the AMCs.
Q. How expense ratio affects the NAV (Net Asset Value)?
Ans. The NAV (net asset value) of the fund appears on investors side after the deduction of expense ratio.
Q. What is a good expense ratio for mutual funds?
Ans. Risk appetites and investment goals vary investors to investors, that’s why one fund may be ideal for an investor, but it may not be good for another investor. Some experts advise to choose fund with expense ratio less than or equal to 1. In simple words, expense ratio above 1 percent is considered high.
Q. How to calculate expense ratio for ETFs (Exchange Traded Funds)?
Ans. Expense Ratio % = [(Total Annual Expense of Fund X 100) ÷ Average Net Assets of Fund]
