How expense ratio affects your mutual fund returns

Much like your home, car, mobile phone, clothes, or favourite ice cream, your mutual fund investments come with a price tag. This cost, known as the expense ratio, is attached to all mutual fund schemes and may impact your overall returns. Keep reading to know how the expense ratio affects returns so you can make better investment decisions and maximise your earnings. 

What is an expense ratio?

 The expense ratio is the management fee you pay to the Asset Management Company (AMC) to manage your investment. A mutual fund scheme is managed by a professional fund manager who researches the market, looks for wealth-creation opportunities, ensures optimal risk management, etc. The expense ratio covers the fee for all of these functions, including agent commission, advertising expenses, and more. 

 Now that you know the theory, it’s time to understand how the expense ratio is practically calculated.

How do you calculate the expense ratio?

The following formula can be used to calculate the expense ratio:

Total expense ratio = (Total expense of the mutual fund scheme/ Total Assets under Management) x 100

Here,

• Total expense of the mutual fund scheme includes the fund’s operating expenses
• Total Assets Under Management (AUM) is the value of funds that the scheme holds at a given time

 So, if the AUM of the mutual fund scheme is Rs 10 lakh and its total expense incurred is Rs 10,000, its expense ratio would be 

 10,000/ 10,00,000 x 100 = 1%

 The Securities and Exchange Board of India (SEBI) has set limits for expense ratios for different mutual fund schemes, as shown below:

How does the expense ratio affect your mutual fund returns? 

The expense ratio is deducted from the profits of a fund. Hence, it affects your mutual fund returns. While the small figures mentioned in the table above may seem inconsequential, they can add up to a lot for a long-term investment. Therefore, picking a fund with a lower expense ratio can benefit you.

Having said that, you must not base your investment decisions solely on the expense ratio. It is equally important to look at aspects like the fund manager’s experience and qualifications, the fund house’s reputation, etc.

If you are concerned about costs, you can consider choosing direct mutual funds over regular ones. The former directly invests your money in the scheme without agent commissions charged by brokers. Therefore, you incur fewer costs. Additionally, you may also choose passive funds as they may have a lower expense ratio than active funds since there is limited buying and selling.

No matter what you choose, make sure the type of fund aligns with your requirements. For example, actively managed equity funds may have a relatively higher expense ratio than passively managed index funds that simply mimic a benchmark index. But it is important to note that equity funds may generate high returns over the long term and be better suited for long-term goals like retirement. So, even though you may pay a lower expense ratio on index funds, you could lose out on the opportunity to earn more by dismissing equity funds.

Conclusion

It helps to look at the expense ratio when selecting a mutual fund scheme. However, do not make it the only criterion for selection. Ultimately, your goal and risk appetite should determine the right type of fund for you, not the expense ratio.

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