If you have been investing in mutual funds regularly, or a new investor looking to invest in mutual funds, it is imperative to learn how mutual funds work. During your learning phase, you may come across different types of mutual funds. One thing that remains common is the term “expense ratio”. But what does it mean and how does expense ratio impact your overall returns from a mutual fund investment?
This article helps you understand the importance of expense ratio and why it is one of the critical parameters while choosing a mutual fund scheme.
What are debt funds?
A debt fund invests in fixed-interest generating securities such as commercial paper, treasury bills, government securities, corporate bonds and other money market instruments. The issuer decides the maturity period and the fixed interest rate you will earn on your investment at the very beginning. This is why the fundamental goal behind such investments is to earn interest income and enjoy capital appreciation.
What is the total expense ratio?
An expense ratio is the annual fees charged by your asset management company for managing your investment. It can fluctuate based on the type of mutual fund you have invested. Simply put, an expense ratio is the cost of operating a mutual fund. It is charged as a percentage of the average asset under management of a particular mutual fund scheme. As per the guidelines by SEBI in September 2018, the expense ratio for debt funds cannot exceed 2.25% whereas, for equity funds, it cannot go beyond 2.5%.[i]
The expense ratio involves numerous components required for the seamless administration of a mutual fund scheme. The three major components of an expense ratio are management fees, cost of administration and distribution fees.
How does the expense ratio impact the corpus of your debt mutual funds?
As stated earlier, expense ratio indicates the annual percentage a fund house can charge for managing an investment portfolio. Hence, if you invest Rs. 20,000 in a fund with an expense ratio of 2%, it means you have to pay Rs. 400 to the fund house to manage your money. This means, if a fund earns returns of 15% and has a total expense ratio (TER) of 2%, your valid returns from the investment would be 13%.
The Net Asset Value of a fund is reported after netting off all expenses and fees. Hence, it becomes vital to know how much you are paying to the fund house or asset management company. While they may appear small, after some years, they can run into lakhs.
Expense ratio implications
A lower expense ratio means more profitability and a higher ratio means less profitability. However, it is not necessary that a high expense ratio may always provide low returns. You may use the expense ratio to differentiate between passively managed funds and actively managed funds.
For example, in the case of actively managed equity funds, a compelling justification for the fees charged by the fund managers is the alpha generated by them. An alpha of 1.0 means the fund has outperformed the index fund by 1%. Similarly, an alpha of -1.0 would indicate the fund underperformed the index fund by 1%. If there is a considerable difference between index funds and the returns of your fund, it is an indicator you need to switch to a better fund house.
Thus, it is crucial to consider the total expense ratio at par with other factors such as the scheme’s size and fund manager’s performance when you invest in debt funds.