Expense Ratio in Mutual Funds: All You Need to Know

As you venture through the trials of adulthood, you forego juvenile tendencies on the journey. This sacrifice doesn’t necessarily diminish certain urges – like indulging in games and interactive media. You can experience the same thrills by pursuing smart investment opportunities and dealing with diverse instruments. 

Within the depths, you will find traditional and modern investment instruments like Fixed Deposits, Mutual Funds, Real Estate, Bonds, etc. The current trend favours those investing in diversified mutual funds, balancing their portfolios between debt and equity funds. If you’re a new investor, you might have noticed something in your returns statement – despite turning a profit, the returns are lesser than anticipated. 

Also Read: Loans Against Mutual Funds: All You Need to Know

Expense Ratio: What is it? 

The missing amount is the annual maintenance levied by mutual funds to finance certain expenses. The size of the mutual fund determines the value of the expense ratio. The expense ratio uses a formula that divides the costs incurred with the total assets of funds owned. 

To understand the expense ratio, let’s simplify this further: 

For example, funds operating with smaller investment pools will utilise a specific amount to optimise their management. It increases the value of the expenses incurred by the fund.

Hence, the more assets you own, the lower will the expense ratio be, and vice versa. Identify the ratio indicated on these funds to estimate the potential returns it may generate. Or else, you may be in for another surprise again! 

Limitations Set by SEBI 

As per the SEBI Mutual Fund Regulations, expense ratios levied by AMCs on mutual funds are bound to certain restrictions under Regulation 52. These strict guidelines protect the interest of investors while ensuring that sufficient financial resources are sent to the capital market. Here, the total expense ratio (TER) permitted is 2.5% (max) for the first ₹100 crores of the average weekly total net assets. 2.22% for the next ₹300 crores, 2% for ₹300 cores and 1.75% for the rest of the assets under management (AUM). 

Furthermore, the SEBI has permitted mutual funds to charge 30 basis points as an incentive to promote engagement in smaller towns (B15 cities). And, as exit load charges, these cities may receive another 20 basis points. 

3 Components of Expense Ratio 

For transparency, the complete data and costs are broken up into different components. These factors play a significant role in the success of mutual funds. Every six months, the accounts statement displays various charges incurred and deducted to meet the costs of expenses. There are three types of important fees deducted as part of the expense ratio. 

1. Management Fees 

The strategising behind mutual fund management takes years of experience to devise the ideal plan appropriately. A fund manager can mitigate these problems with their high level of experience, education and professional credentials. Once in charge of your funds, they spend considerable time rigorously researching market trends to find the best investment opportunities for you. Hence, the fee charged is in compensation for availing of their expertise. 

The management fees are usually charged annually – between 0.50% to 1% of the funds’ assets. 

2. 12B-1 Fee 

It gets its name from the Securities and Exchange Commission (SEC) rule that authorises a fund to charge them. Most mutual funds levy this fee for their advertising and promotional services. Based on this, the charges cover the allocation costs, including marketing and the sale of mutual fund shares. The fee deducted is equal to the percentage of assets deducted from your funds. 

3. Administrative Charges 

These administrative duty costs are for maintaining funds to ensure the operations run seamlessly. The maintenance expenses include investor records, entry and exit fees of the portfolio assets, customer support, information emails and other ways of communication. However, the administrative fees vary among investors, usually mentioned as a percentage of fund assets. 

So, a lower expense ratio signifies more profitability, unlike a higher rate. For moderate-risk investors, this is an important expense to factor into their investment strategies. However, you could use the expense ratio to identify actively and passively managed funds.