Mutual Funds expense ratio: Calculations, factors affecting it & its importantance.

What is expense ratio?

Mutual Funds pool investments from a large number of investors and invest them in what an asset manager evaluates as profitable assets. To manage an investment fund, mutual fund, or other types, several costs are incurred. The expense ratio is the total percentage of the assets under management that must be paid to asset managers, compliance/legal fees, marketing expenses, etc.

Is expense ratio similar to the operating ratio?

It can be interpreted as the operating ratio of the fund since the expense ratio is expressed as a percentage of the average assets under management (AUM) where:

• Total Expense: Cost of hiring a management team that will identify profitable opportunities. It also includes compliance charges related to auditors and fund marketing.

• Assets under management: The total amount of money invested in the fund and is usually time-weighted.

As an example, let’s take a look at Nippon India Large Cap Fund Direct Growth with a fund size of approximately 34,432 crores and an expense ratio of 0.65%. An investor with an investment of INR 100,000 will have to chalk out INR 650 annually as expenses.

The expenses are deducted from the returns of the fund’s assets and reduce the assets of the fund. These charges are incurred even in periods where funds make negative returns. The expense ratio can range from 0.5% to 2.25% and depends on:

• Size of the fund: Larger funds usually have lower ratios due to the economies of scale.

• Type of management: Actively managed funds require more balancing and hence more management, therefore the expense ratio is higher for them when compared to indexed or passively managed funds.

• Type of fund: Equity funds require more scrutiny and surveillance from fund managers and hence need higher costs for a large management team.

Motilal Oswal Nifty 500 Index Fund with a fund size of INR 2,060 crores, has an expense ratio of only 0.20% which is among the lowest. This is due to the fact that it is an index fund and does not have to be rebalanced frequently. In addition, the fund size is also significant so economies of scale come to play.

Compare this to the SBI Small Cap Fund, which is a large fund with an AUM of nearly INR 33,285 crores but has an expense ratio of 0.67%. This is due to the fact that it involves more balancing and since small-cap stocks have less readily available information, the fund has to hire a large management team to identify good stocks.

While it is not easy to assess the ideal fund ratio due to a number of subjective factors, nevertheless, SEBI has provided guidelines for limits on expense ratios for different schemes here.

Costs not included in expense ratio:

The expense ratio usually includes costs that have to be paid irrespective of the fund's performance. Therefore, costs that are not included are:

• Trading Costs: Costs incurred in buying and selling securities are not included in the expense ratio.

• Loads: Front-end and back-end loads are excluded because they are independent of the fund management.

• Holding period penalties: Some schemes may include charges that include penalties if the fund is redeemed before a specified time. This is not included in the fund expense ratio.