Expense Ratio – What it is in Mutual Funds?
Expense ratio in Mutual Funds can decrease your returns.
It is a common word in the Mutual Fund monthly Fact sheet when you are reading about funds information.
In addition, You may have noticed that this ratio is not the same for all the funds.
This ratio may be between 0.35% to 2.5% depending on the category and type of funds.
In addition, If the fund category same, this ratio may be different from one mutual fund to another.
This ratio exists in NPS, ULips also.
But in this article, I will explain about mutual fund expense ratio for simplicity purposes.
Read this article about what is a mutual fund and what is its strong Structure. Click this link to read.
What is the Expense Ratio in Mutual Funds???
Let me explain to you first about the expense ratio in mutual funds.
We all buy and sell mutual fund units.
But in the background for managing our fund, the mutual funds will spend some money as an expense.
This expenditure will be for the agent’s commission ( Distributors), fund management fees, promoting expenses, and registrar fees, etc.
As per Sebi Regulation, The mutual fund company can charge the following expenses.
- The total expenses ratio should not cross 2.5% of the 1st 100 crores of weekly average total net assets.
- 2.25% for the next 300 crores.
- 2% for the next 300 crores.
- 1.75% for the rest of the Assets under Management (AUM).
In addition, The maximum expense ratio for the Debt Mutual funds is 2.25%.
However, the Sebi allowed all mutual fund companies to charge extra 30 basis points for smaller towns i.e Beyond Top 15 cities. ( B15 cities).
The above expense ratio is as of date 16th, December 2019. The source is www.cleartax.in.
But Sebi will revise this expense ratio from time to time.
have you ever thought that Who has to pay these expenses?
Obviously, You have to pay for these expenses.
In addition, expenses will be deducted on a daily basis from your fund.
Moreover, after deducting expenses only NAV of the fund is Published in the AMFI website.
How expenses will be deducted from the fund???
Let us assume that you have invested Rs.1,00,000 in a mutual fund scheme.
In addition, the fund gave 0.5% return in a day and the expense ratio for the fund is 1%.
Do you think that your fund value will Rs.1,00,500?
As you got 0.5% ( Rs.500) return for 1 day.
No, your fund value will not be Rs.1,00,500.
You have to deduct the expense ratio from the above value. ( Rs.1,00,500).
1% of Rs.1,00,000 will be Rs.1000.
But the above value Rs.1000 for a full year ( as 1% is for 365 days).
So, we should not deduct Rs.1,000 from the fund value for a single day.
Hence, We have to calculate the single day cost, and then we have to deduct it from Rs.1,00,500 fund value.
Single-day expense assuming a 1% expense ratio per year is Rs.2.74.
So, the final value of the fund value after considering a 0.5% return, a 1% expense ratio for Rs.1,00,000 for a single day is given below.
- The value of Rs.1,00,000 after 1 day = Rs.1,00,000 + 500 ( 0.5% return on Rs.1,00,000 ) – Rs.2.74 ( 1%*1,00,000/365).
- = Rs.1,00,497.
Hence, the actual return is 0.497%, not 0.5%.
However, You will ask me whether this small % change will affect my returns?
The answer to this is simple.
If you are looking to invest for 3 months to 1 year, then this small change in the return does not make any difference.
But if you are looking to invest for 5,10, and for 20 years and more, then the difference in the actual return will be huge.
Let us compare our fund value with and without expense ratio.
Now, let’s calculate the fund value of the “Paisa Health” Equity Fund. ( for understanding purpose).
In addition, Let’s calculate the fund value for assuming expense ratio of 0%,1%,1.5%, and 2% respectively for 25 year period, and return on investment is 12% per year.
Let’s Calculate the fund value for a one-time investment of Rs.1,00,000 with different expense ratios.
You can find from the above image that the ” Paisa Health Fund” performance decrease with an increase in the expense ratio of the fund.
In addition, the fund value has grown to 16.9 lakhs in 25years with a “0%” expense ratio.
Whereas the fund value has grown to 10.8 lakh only with a 2% expense ratio.
So, always remember the mutual fund’s return is calculated after deducting costs only.
In addition, if a fund in the same category has more expense ratio has to generate or perform better than the fund which has a low cost.
In the above image, You can see Fund A ( having higher costs) has to deliver a 15.6% return on investment.
Similar to get a 13.1% return on an investment after expenses like in the case of Fund A.
But a higher return is not easy.
In addition, there is no guarantee that funds having more expense ratios will give higher returns and the fund which has a low expense ratio will give low returns.
So, it is always wise to consider a fund which is having low expenses along with other parameters( in selecting a fund).
Comparison of Hdfc Tax Saver Fund Vs ABSL Tax relief-96 fund.
You can find that Hdfc tax saver fund return grade is below average while at the same ABSL Tax relief – 96 fund return grade is above average.
But, you can see Hdfc Tax saver has a low expense ratio and delivered a higher return compared to the Birla Tax relief’ Fund which has high costs.
In addition, Historically the funds which have low costs have given a better return than the funds having higher costs.
So, as the more low-cost funds are giving better returns logically and also with back testing.
It is wise to choose a mutual fund scheme that has a low cost.
Read the article about the Cost Inflation Index. Click this link to read how it affects your investment taxes.
Also read the article about How Life Insurance agents are earning more return than you from endowment Life Insurance Policies. Click this link to read.