You come across the word expense ratio every time you read about mutual funds. Ever wondered how it works? Here is what it is: Expense ratios a portion of your invested money that goes into managing your fund. These expenses include fund management fee, expenses incurred on selling and marketing, fees paid to the registrar and transfer agent and other expenses directly related to running the scheme, agent commission, promotional expenses, etc.
Expense ratio is different for different funds. Mutual Fund Regulator –SEBI(Securities and Exchange Board of India) has put a limit on the expenses charged based on the type of fund. This will regulate mutual fund companies from earning unjustified profits and charging unjustified expenses on the customers.
A fund can charge a maximum of 2.5 percent of the average weekly net assets. The NAV of the fund is calculated after deducting this charge. SEBI has made the expense ratio slabs for mutual funds such that higher the AUM (assets under management) size of a scheme, lower the expense ratio; and the other way around.
When does expense ratio matter?
Here’s an indicative list as to when it matters most:
Index funds are managed passively. You need to compare different index funds in a category and If you see an index fund having a higher expense ratio than most other peers, then its best that you avoid it.
Debt oriented schemes are income funds and Equity oriented schemes are for growth. Debt funds are not created to generate high returns like equities. Hence, you must check both the asset size and the expense ratio with similar category peers. A fund with mediocre returns and high expense ratio has to be re-looked, before investing.
If you hold an equity fund that is struggling to beat its benchmark, it is possible that its expense ratio is preventing it from inching up by 1-2 percentage points over its benchmark. Hence, if you are reviewing some of your under performing funds in your portfolio, you will do good if you check their expense ratio as well.
When you are interested in a fund-of-fund or a feeder fund that invests in another international fund, check the offer document for the expense ratio. You should understand that the expense ratio will be what the fund incurs plus the expense of the underlying funds.
When you intend to hold equity funds for a long duration of time or if you have invested large sum of money in Mutual funds then expense ratio is something you should look out for as higher expense ratio can considerably lower your return over a long period of time.
Whatever be your investment either in Equity / Balanced or Debit funds and regardless of the quantum of amount you intend to invest the simplest way to save on expense ratio is to invest in the funds in DIRECT mode. By investing in DIRECT mode rather than the regular mode, you can save between 50% – 70% of the expense ratio and this savings has the potential to add upto 1% per annumm returns to your Mutual fund investment portfolio.
Most of the mutual funds which are quoted today have 2 NAV’s which are declared. There is a NAV for regular mode of investment and another NAV for DIRECT mode of investment. Generally the NAV for DIRECT mode is always higher than the NAV for regular mode. In the regular mode,the distributor gets upfront and trail commissions while in the DIRECT mode the distributor gets nothing. The distributor commissions are part of the reason why the expense ratio are higher in regular mode than in DIRECT mode.
Below you can compare the NAV of IDFC Infrastructure fund Direct Plan (NAV:17.513) for growth and the expense ratio of 0.89% for Direct Plan versus a lower NAV of 16.53 for Regular plan and a higher expense ratio of 2.52%.
The savings in the expense ratio in this fund is 65%
So the next time you invest into mutual funds remember to check out the expense ratio and invest in DIRECT mode to save on charges and earn higher returns.