The expense ratio of a mutual fund is the annual fee you pay to the AMC for the management and operation of the investment fund. It is generally expressed as a percentage and includes the fund’s annual operating expenses like portfolio management fees, marketing expenses, and allocation charges. While the expense ratio of a fund depends on the total assets under management, a lower expense ratio is better as it means lower investment costs. You do not need to pay the expense ratio separately since it is deducted from the investment value daily.
Expense ratios in mutual funds are an essential comparison tool that can help you select the right funds for your portfolio. Investors generally look for a ‘good’ expense ratio when selecting MFs. Good expense ratios can vary depending on whether the fund is actively or passively managed. Typically, expense ratios between 0.5% and 0.75% are considered ‘good’ for actively managed funds. Ratios above 1.5% are considered high.
In this article, we explore the meaning of the expense ratio, its formula, how it works, and its impact on returns with relevant examples. We also explain what is a good expense ratio and how you can identify funds with low ratios to optimise returns.
What is expense ratio?
The expense ratio is an annual fee charged by mutual funds to cover their operational costs. This fee includes various expenses such as management fees, distribution charges, advertising costs, and other administrative expenses necessary for running the fund. It is expressed as a percentage of the fund's assets and helps ensure smooth functioning while compensating the fund manager for managing investments.
This is represented by the expense ratio formula, which is calculated by dividing total expenses by the total assets of the funds. The higher the asset base, the smaller the ratio, and vice versa, assuming total expenses stay constant.
How does expense ratio work?
The expense ratio serves as the fee associated with owning a mutual fund or ETF, akin to a management fee paid to the fund company for the privilege of holding the fund. It is expressed as a percentage of your investment in the fund, with, for instance, a 0.30 percent expense ratio meaning an annual payment of Rs. 30 for every Rs. 10,000 invested. This fee is incurred annually if you retain ownership of the fund throughout the year. It is important to note that attempting to sell the fund just before the one-year mark won't circumvent the cost. In the case of an ETF, the management company discreetly deducts the expense from the fund's net asset value daily, making it nearly imperceptible to investors.
Why it’s important to understand expense ratios?
Understanding expense ratios in mutual funds is essential for investors since it helps them compute how much they will be paying for owning mutual funds over the course of a year. A higher expense ratio can eat away at your investment returns. Even a 0.5% change in the expense ratio of a fund can have a significant impact on your total corpus.Therefore, it is important for investors to compare mutual fund schemes and consider if the higher expense ratio indeed justifies the fund’s returns.
Over time, a low expense ratio can help reduce investment costs and boost your returns. For instance, consider two mutual funds, Fund X and Fund Z. Both funds offer annual returns of 12%. However, Fund X has an expense ratio of 0.5%, while Fund Z has an expense ratio of 1.2%. Fund X has a better potential for higher returns than Fund Z simply because of its lower expense ratio. A low ratio means more of your funds will be reinvested instead of being diverted towards meeting operating and management costs. In other words, a higher proportion of your investment will benefit from the compounding effect.This makes funds with lower expense ratios more attractive than their peers. Expense ratios of over 1% are considered high and should be avoided.
What is a good expense ratio for a mutual fund?
A good expense ratio for a mutual fund depends on the investment goals, risk tolerance, and other individual factors of the investor. Generally, a low expense ratio is good for a mutual fund because it means that more of the investor's money is being invested rather than being used to cover operating costs.
Several factors dictate whether an expense ratio is deemed high or low. For investors, an ideal expense ratio ranges from 0.5% to 0.75% for actively managed portfolios. Anything exceeding 1.5% is generally regarded as high.
What is the expense ratio formula?
Expense Ratio= Total expenses/Average AUM
Where:
- Total expenses: Encompassing the expenses borne by the AMC, including the fund manager's remuneration, marketing, distribution outlays, as well as legal and audit expenditures.
- Average AUM (AUM): Reflecting the overall value of funds pooled from all investors in a particular fund.
How to calculate expense ratio in mutual fund?
Let us consider a fictional equity mutual fund with Assets Under Management (AUM) totaling Rs. 800 crores. The cumulative expenses incurred for various components, such as the fund manager's fees, marketing, and distribution, add up to Rs. 16 Crores.
Applying the expense ratio formula:
Expense Ratio= Total expenses/Average AUM
Expense Ratio= Rs. 16 Crores/ Rs. 800 Crores = 2%
This signifies that each investor will contribute 2% annually as the expense ratio to the Asset Management Company (AMC). This deduction occurs daily throughout your investment tenure in the scheme.
What is an expense ratio example?
For example, if a mutual fund has an expense ratio of 1%, it means that the mutual fund company charges a fee of 1% of the total assets under management to cover its operating costs. If the mutual fund has total assets under management of Rs. 10,00,000, the mutual fund company will charge Rs. 10,000 as an expense ratio.
What are the components of Expense Ratio?
The expense ratio is a critical metric for investors in mutual funds, representing the total annual expenses incurred by a fund relative to its average assets under management (AUM). Understanding the various components that make up the expense ratio is essential for making informed investment decisions. Below, we delve into the key components of the expense ratio.
1. Management fees
Management fees are a primary component of the expense ratio, typically accounting for the largest portion of the total expenses. These fees are paid to the fund manager for their expertise in selecting securities and managing the portfolio. The amount charged can vary significantly among different funds, often based on the fund's investment strategy, size, and performance. A fund with an experienced management team may charge higher fees, but investors often expect better returns in exchange for this added cost. It’s crucial for investors to evaluate whether the management fees align with the potential for returns when assessing different funds.
2. Maintenance expenses
Maintenance expenses cover the everyday operational costs of running a mutual fund. This includes administrative costs, record-keeping, regulatory compliance, and various overhead expenses. Maintenance expenses can also encompass the costs associated with custodian services, which hold and safeguard the fund's assets. These costs are vital for ensuring that the fund operates smoothly and adheres to regulatory requirements, ultimately protecting investors' interests. Even though these expenses are generally smaller than management fees, they can still impact the overall returns on investment.
3. 12B-1 Fee
The 12B-1 fee is a specific type of expense that funds may charge to cover distribution and marketing costs. This fee is named after the SEC rule that allows mutual funds to charge this expense. It is typically used to pay for advertising, promotional activities, and the compensation of brokers who sell the fund shares. Although this fee can be beneficial for increasing a fund's visibility and attracting new investors, it is essential for current shareholders to understand its implications. Some funds charge a flat percentage, while others may have varying rates based on the sales and marketing strategies employed.
4. Entry load
An entry load is a fee charged when an investor purchases shares in a mutual fund. This fee is intended to cover the costs associated with processing new investments and is usually expressed as a percentage of the investment amount. However, many countries, including India, have banned entry loads, leading to a shift towards a more transparent fee structure. In instances where entry loads are applicable, investors should factor this into their cost analysis, as it can impact the effective investment amount and overall returns.
5. Exit load
An exit load is a fee that investors incur when they redeem their shares from a mutual fund before a specified period. This fee is designed to discourage short-term trading, which can adversely affect fund performance. Exit loads vary among funds and may differ based on the duration of the investment. Understanding the exit load is critical for investors considering short-term investments, as this fee can diminish returns if they decide to withdraw their investment prematurely.
6. Brokerage fees
Brokerage fees are costs incurred when a mutual fund buys or sells securities within its portfolio. These fees can fluctuate based on the trading activity of the fund and are typically included in the overall expense ratio. A fund that engages in frequent trading may incur higher brokerage fees, which can ultimately reduce investor returns. It’s essential for investors to consider the trading strategy of the fund and how it may affect the brokerage fees and, consequently, the expense ratio.
Significance of Mutual Fund Expense Ratio
The expense ratio plays a crucial role in shaping your mutual fund journey. As demonstrated by the examples, a higher expense ratio correlates with diminished returns. However, it's imperative to discern that a lower expense ratio doesn't necessarily translate to a superior mutual fund. A fund with a reduced expense ratio may prove just as proficient, if not more, in delivering optimal returns. Regular funds, with their distribution through intermediaries, inherently feature higher expense ratios compared to direct funds. This difference arises because direct funds are invested in directly through the AMC, bypassing intermediary commissions that contribute to the expense ratio.
Over time, these commissions can significantly erode your returns. When faced with the choice between two comparable mutual funds, the expense ratio emerges as a crucial factor in decision-making. For instance, in comparing two large-cap equity funds—A and B—with similar holdings and objectives but expense ratios of 1.5% and 2%, respectively, selecting fund A becomes the logical preference. The impact of the expense ratio is particularly pronounced in debt funds due to their relatively lower returns. A 7% return with a 2% expense ratio, for instance, dwindles to 5%, falling short of effectively outpacing inflation.
How does the Expense Ratio affect returns
The expense ratio is an important factor that can impact your mutual fund returns. A higher expense ratio means that a larger portion of your returns will be deducted as fees, thereby reducing your overall returns. On the other hand, a lower expense ratio can help you maximise your returns.
What are low-expense ratio mutual funds?
Low-expense ratio mutual funds are mutual funds that charge a lower fee to cover their operating costs. Low-expense ratio mutual funds are considered attractive to investors because they offer lower fees, which can improve the overall returns on investment.
How to find funds with low expense ratios?
Avoiding high expense ratios in mutual funds can be instrumental in boosting your long-term returns. However, you may find it a little difficult to select funds with low expense ratios. Here’s a quick guide on how to find funds with low expense ratios:
- Consider adopting a passive approach to investing. Passively managed funds have lower expense ratios compared to actively managed funds. Passively managed funds do not have researchers constantly choosing assets to buy and sell.
- Index mutual funds generally have a low expense ratio since they seek to replicate the performance of a particular index like Sensex or Nifty 50. Since these funds are passively managed, there is no need to ideate an investment strategy or conduct research. This ensures low management costs and, therefore, low expense ratios.
- You can also consider investing in ETFs or Exchange Traded Funds. ETFs are cost-effective, passively managed funds that track the performance of a specific index.
- The expense ratios of funds are listed on the AMFI website as well as aggregator sites. You can compare this data and choose funds with the lowest expense ratio within a given fund category.
- You can also consider investing in mutual funds through direct plans instead of regular plans. Direct plans do not have the distribution commission associated with regular plans. The absence of an intermediary commission means a lower expense ratio.
What is the interest expense ratio in mutual funds?
The interest expense ratio in a mutual fund is the amount of interest paid by a mutual fund to borrow money to invest in securities. The interest expense ratio is included in the expense ratio calculation and is expressed as a percentage of the total assets under management.
Impact of expense ratio on mutual fund returns
A prevalent fallacy is that a greater cost ratio signals better management of a mutual fund and a higher likelihood of profit generation. Mutual funds with low expense ratios yet managed by competent managers who make accurate market predictions can also produce significant returns. Mutual funds with a high-cost ratio can be managed aggressively for larger returns or invest in firms with a higher possibility of success. A higher level of revenue will compensate for the increased level of costs.
While the cost ratio is significant, it is not the only factor to consider when choosing a mutual fund plan. The greater expenditure ratio might often mask good profits. If market tracking is not your thing and you find it tough to grasp, invest via Bajaj Finance platform. You can invest in carefully curated mutual funds in a paperless and hassle-free manner.
Expense Ratio Limits set by SEB
The Securities and Exchange Board of India (SEBI) has set expense ratio limits based on the type of fund and it’s AUM.
| AUM in Crore | TER limit for equity schemes | TER limit for all the schemes other than equity |
| Rs. 0 – 500 crore | 2.25% | 2.00% |
| Rs. 501 crore -750 crore | 2.00% | 1.75% |
| Rs. 751 crore -2,000 crore | 1.75% | 1.5% |
| Rs. 2,001 crore - 5000 crore | 1.6% | 1.35% |
| Rs. 5,001 crore - 10,000 crore | 1.5% | 1.25% |
| Rs. 10,001 crore - 50,000 crore | 0.05% total expense ratio reduces with every increase of Rs. 5000 crore of daily net assets | 0.05% total expense ratio reduces with every increase of Rs. 5000 crore of daily net assets |
| Remaining assets | 1.5% | 0.80% |
For passively managed MFs:
Fund Type |
Max Expense Ratio |
Close-ended equity-oriented or interval schemes |
1.25% |
Non-equity-oriented close-ended schemes |
1.00% |
Exchange-Traded Funds / Index Funds |
1.00% |
Fund of Funds (Actively managed equity) |
2.25% |
Fund of Funds (Actively managed non-equity) |
2.00% |
Fund of Funds (Invest in Liquid Funds, Index Funds, or ETFs) |
1.00% |
Factors influencing expense ratios
Expense ratios are crucial for investors to understand, as they directly affect the returns on their investments in mutual funds. Several factors influence the expense ratios of mutual funds, shaping how much investors pay for managing their investments. Here are the primary factors that can affect expense ratios:
Fund Type: Different types of mutual funds come with varying levels of management and operational costs. For example, actively managed funds typically have higher expense ratios compared to index funds due to the intensive research and trading activities involved in managing an active portfolio. Conversely, passive funds aim to replicate the performance of a benchmark index, resulting in lower costs.
Fund Size: The size of a mutual fund, or its assets under management (AUM), plays a significant role in determining its expense ratio. Larger funds can benefit from economies of scale, spreading fixed costs over a larger asset base. This often leads to lower expense ratios as the fund grows. Conversely, smaller funds may have higher expense ratios due to a smaller asset base over which to distribute fixed costs.
Management Style: The investment strategy employed by the fund manager can significantly influence expense ratios. Funds that require extensive research and frequent trading tend to incur higher costs, leading to elevated expense ratios. In contrast, funds with a buy-and-hold strategy generally have lower costs associated with trading and research.
Distribution and Marketing Expenses: Funds that allocate significant resources to marketing, advertising, and distribution often have higher expense ratios. The 12B-1 fees associated with these marketing efforts can increase the overall costs for investors. Understanding these expenses can help investors gauge the true cost of their investments.
Regulatory and Compliance Costs: Mutual funds must adhere to various regulatory requirements, which can incur costs. These compliance expenses can vary based on the fund's investment strategy and geographic focus, potentially affecting the expense ratio. A fund with complex regulatory obligations may have a higher expense ratio compared to those with simpler compliance requirements.
By understanding these factors, investors can better assess the expense ratios of mutual funds and make informed decisions regarding their investment choices.
Comparison of Expense Ratios
- Definition: Expense ratios indicate the annual cost of managing and operating a mutual fund, expressed as a percentage of the fund's average assets.
- Impact on Returns: A higher expense ratio can reduce investor returns, as it directly deducts from the fund's performance.
- Active vs. Passive Funds: Actively managed funds often have higher expense ratios due to intensive management, while passive funds like index funds typically have lower ratios.
- Comparison Criteria: Consider fund category, investment strategy, and fund performance while comparing expense ratios.
- Long-Term Effects: Lower expense ratios can lead to better compounding and higher returns over time.
Things to remember about Expense Ratio
Here are some key takeaways to keep in mind:
- Understanding cost to AMC: The expense ratio represents the fee paid to the Asset Management Company (AMC) for fund management.
- Consideration of investment objectives: While a lower expense ratio is generally preferable, it is essential to align your investment goals with the mutual fund's characteristics, rather than solely opting for those with lower expense ratios.
- Difference between regular and direct plans: Regular plans generally have higher expense ratios compared to direct plans, and actively managed funds generally incur higher expenses than passively managed ones. Read more about the difference between direct and regular mutual funds.
- Significant impact on debt funds: Debt funds are more affected by the expense ratio, given their relatively lower returns. Deducting expenses can leave them less equipped to outperform inflation.
- Comparative tool: Utilise the expense ratio as a tool for comparing different mutual funds. Additionally, be aware that the deduction is made daily from your investment amount and does not require a separate payment to the AMC. A fund with a higher Assets Under Management (AUM) is likely to have a lower expense ratio due to the distribution of management costs among a larger investor base.
Who should invest in lowest expense ratio mutual funds?
Investors who seek to maximise returns and prefer low-cost options should consider mutual funds with the lowest expense ratios. These funds are ideal for long-term, cost-conscious investors, as lower expenses help compound gains over time. Passive investors, who favour index or exchange-traded funds (ETFs), can benefit significantly, as these funds track market performance without active management costs. Young investors or those with smaller investment amounts also gain, as they retain more of their capital growth. Additionally, conservative investors who prioritise stable returns over frequent trading often prefer low-expense funds, ensuring cost efficiency aligns with their risk tolerance.
How to lower your investment expense ratio?
Lowering your investment expense ratio is an effective strategy for maximising returns, especially over the long term. By reducing costs associated with fund management, investors can retain more of their investment’s growth. Here are some key ways to minimise your expense ratio.
Choose passive funds overactive funds
Passive funds, such as index funds or ETFs, typically have lower expense ratios than actively managed funds. Because they simply track a market index rather than employing costly research and analysis, passive funds are less expensive and often provide similar long-term returns to active funds.
Opt for direct mutual fund plans
Many mutual funds offer a direct plan option, which excludes distributor fees and commissions, leading to a lower expense ratio. By investing directly with the mutual fund company rather than through an intermediary, investors can reduce annual expenses and improve returns.
Consider fund size and investment tenure
Large mutual funds with more assets under management (AUM) can spread fixed costs over a larger investor base, resulting in a lower expense ratio. Additionally, for long-term investments, even a small reduction in the expense ratio can make a substantial difference. Carefully selecting funds with low expense ratios aligns your investment strategy with financial goals more efficiently.
Key takeaways
- Lowering your expense ratio enhances long-term returns by reducing annual costs associated with fund management.
- Passive funds, such as index funds and ETFs, generally have lower expense ratios than actively managed funds due to minimal management costs.
- Direct mutual fund plans exclude distributor fees, lowering expense ratios and allowing investors to retain more of their returns.
- Larger funds often have lower expense ratios as they spread fixed costs across more assets, benefiting investors.
- For long-term investments, even a slight reduction in expense ratio can lead to significant gains through compounding.
Taxation on lowest expense ratio mutual funds
Taxation on lowest expense ratio mutual funds plays a crucial role in determining net returns for investors. Although low-expense funds reduce annual costs, understanding the tax implications on equity, debt, and hybrid funds helps in making more informed investment choices. Here’s a breakdown of the tax treatment for each type.
Equity mutual funds
Equity mutual funds primarily invest in stocks and are taxed based on the holding period of the investment. In India, the tax structure for equity funds favours long-term holdings to encourage sustained investments.
- Holding Period: Short-term (less than 12 months) and long-term (12 months or more).
- Short-Term Capital Gains (STCG): Taxed at 15%.
- Long-Term Capital Gains (LTCG): Gains up to ₹1 lakh are tax-exempt. Gains exceeding ₹1 lakh are taxed at 10% without indexation benefits.
Equity Mutual Funds Tax Table
Holding Period |
Capital Gains |
Tax Rate |
Less than 12 months |
Short-Term |
15% |
12 months or more |
Long-Term |
10% on gains above ₹1 lakh |
Debt mutual funds
Debt mutual funds invest in fixed-income securities such as bonds and are suitable for conservative investors. Their tax treatment differs significantly from equity funds, with a focus on a longer holding period for tax benefits.
- Holding Period: Short-term (less than 36 months) and long-term (36 months or more).
- Short-Term Capital Gains (STCG): Added to the investor’s income and taxed according to the applicable income tax slab.
- Long-Term Capital Gains (LTCG): Taxed at 20% with indexation benefits, which can reduce the effective tax burden by adjusting for inflation.
Debt Mutual Funds Tax Table
Holding Period |
Capital Gains |
Tax Rate |
Less than 36 months |
Short-Term |
Based on income tax slab rate |
36 months or more |
Long-Term |
20% with indexation benefits |
Hybrid mutual funds
Hybrid mutual funds invest in a mix of equity and debt, and their taxation depends on the equity allocation. Funds with more than 65% equity allocation are treated as equity funds, while those with less than 65% equity are treated as debt funds for tax purposes.
- Equity-Oriented Hybrid Funds: Taxed similarly to equity mutual funds, with a 12-month holding period for long-term classification.
- Debt-Oriented Hybrid Funds: Taxed like debt funds, with a 36-month holding period for long-term classification.
- Balanced Advantage Funds: These funds adjust their equity and debt allocation dynamically, and their tax treatment may vary depending on the exact proportion of equity investment.
Hybrid Mutual Funds Tax Table
Fund Type |
Holding Period |
Tax Rate |
Equity-Oriented Hybrid |
<12 months (STCG) |
15% |
|
≥12 months (LTCG) |
10% on gains above ₹1 lakh |
Debt-Oriented Hybrid |
<36 months (STCG) |
Based on income tax slab rate |
|
≥36 months (LTCG) |
20% with indexation benefits |
In summary, understanding the tax impact on different types of low-expense mutual funds allows investors to strategically manage their investments. Lower expense ratios boost net returns, while favourable tax strategies based on fund type and holding period further maximise gains.
Conclusion
The expense ratio is more than just a fee; it is a critical factor that can significantly impact returns. Investors must carefully weigh the cost against the benefits offered by a mutual fund, considering their specific financial goals and risk tolerance.
