Mutual fund houses charge investors for managing their money. This, in industry parlance, is referred to as the fund’s ‘expense ratio’.
Costs such as fund management fees, trustee fees, audit fees, registrar fees, and selling and distribution expenses are what go into expense ratio.
The expense ratio is a charge on the net assets. So, if the value of your investment in a fund is ₹10,000 and imposes an expense ratio of 2 per cent, then you get charged ₹200. The higher the expense ratio, the lower your net returns.
Equity schemes are allowed to charge a maximum of 2.5 per cent for the first ₹100 crore (weekly average net assets), 2.25 per cent for the next ₹300 crore, 2 per cent for the subsequent ₹300 crore and 1.75 per cent for the remaining assets. For debt-based schemes, it is 0.25 per cent lower across slabs.
To increase participation in mutual funds from smaller cities, SEBI allowed mutual funds to charge up to 30 basis points more on daily net assets.
This will happen if new inflows from cities beyond the top 15 are at least 30 per cent of gross new inflows or 15 per cent of average assets.
How are returns impacted? As net asset values (NAV) are computed after deduction of expense ratio, a higher expense ratio can drag down overall returns.
For instance, consider two funds, both with a 10 per cent return. Say Fund A charges 1.5 per cent as expense ratio and Fund B charges 2.5 per cent.
The investor will make a net return of 8.5 per cent in Fund A, while the investor in Fund B has to be content with 7.5 per cent. While this 1 per cent difference may not seem significant in the near term, it does have a sizable impact over longer periods.
While actively managed funds have higher expense ratios, passively managed funds such as index funds sport a lower number. Debt funds also report a lower levy.
Do not choose mutual funds based only on expense ratio. Consider other factors such as fund house pedigree, long-term track record and portfolio quality. You will be better off with a fund that charges more but still delivers superior returns than a laggard that charges less.
Investors cannot dodge expense ratio, but they can minimize its impact with investments in direct plans.
Such plans have a lower expense ratio by skirting expenses related to distributor commissions.
For instance, HDFC Equity fund charges an expense ratio of 2.24 per cent for its regular plan and 1.44 per cent for its direct plan.