Expense Ratio : What It Is and How It Impacts Your Investments

Are you curious about how to invest your money? One of the things that you should consider when investing in mutual funds or exchange-traded funds (ETFs) is the expense ratio. It is a fee that fund companies charge to manage their funds, and it can impact your investment returns.

In this blog, we’ll explain what the expense ratio is, why it’s important, and how it can affect your investment returns. So, let’s dive into the world of expense ratios and see how it can affect your investments!

What is Expense Ratio in Mutual Funds? 

Expense ratio in mutual funds is a term used in finance. It refers to the percentage of a mutual fund’s assets that are used to cover the fund’s operating expenses. It includes fees such as management fees, administrative fees, and other costs incurred in running the fund. Mutual fund investors can use the total expense ratio (TER) as a useful metric to compare the costs of different funds.

Therefore, a high expense ratio can eat into your returns, making it harder to achieve your financial goals. For example, if you invest ₹1,000 in a mutual fund with an expense ratio of 2%, you will pay ₹20 in fees annually, regardless of how well the fund performs. This can add up over time and significantly reduce your returns.

How to Calculate Expense Ratio?

It is the annual fee charged by mutual funds or exchange-traded funds (ETFs) to cover their operating expense ratios. The fund calculates it by dividing its total operating expenses by its average net assets over a particular period of time, usually a year.

Formula 

Expense Ratio = (Total Fund Costs / Average Net Assets)

What are its Components? 

• Management Fees: The fund manager charges these fees for managing the portfolio.
• Administrative Expenses: These include expenses such as legal fees, custodial fees, and accounting fees.
• Marketing and Distribution Expenses: These include expenses incurred in marketing and distributing the fund.
• Other Expenses: These include expenses such as audit fees, taxes, and other miscellaneous expenses.

The operating expense ratios include various costs such as management fees, administrative expenses, legal and audit fees, marketing and distribution expenses, and other costs associated with managing and operating the fund. The total operating expenses are then expressed as a percentage of the average net assets of the fund to arrive.

For example, if a mutual fund has total operating expenses of ₹1 crore and average net assets of ₹100 crore, the ratio would be 1%. This means that the fund charges 1% of the average net assets as an annual fee to cover its operating expenses.

Why Does the Ratio Matters? 

This an important factor to consider when investing in mutual funds or ETF as it directly impacts your investment returns. 

A high expense ratio means that a significant portion of your investment returns goes towards paying fees, which can reduce your overall investment returns. 

For example, if you invest ₹10,000 in a fund with a 2% expense ratio, you would pay ₹200 in fees annually. However, if you invest the same amount in a fund with a 0.5%, you would only pay ₹50 in fees annually.

Therefore, it’s important to consider this ratio when selecting mutual funds or ETFs, as it can significantly impact your investment returns over the long term. By choosing funds with lower expense ratios, you can potentially increase your investment returns and achieve your financial goals faster.

What are the Types of Funds with Expense Ratios? 

There are different types of funds that you can choose from. Here are a few types of funds with expense ratios:

• Mutual Funds: Mutual funds are a type of investment fund that pools money from multiple investors to purchase securities. Mutual funds typically charge a management fee. The expense ratio for mutual funds can range from less than 0.10% for low expense ratio mutual funds to over 2% for some actively managed funds.

• Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds, but they are traded on an exchange like a stock. ETF expense ratio is typically lower than the expense ratio for mutual funds. Thus, the ratio can range from less than 0.10% for some index ETFs to over 1% for some actively managed ETFs.

• Index Funds: Index funds are a type of mutual fund or ETF that tracks a specific index, such as the S&P 500. Index fund expense ratio is lower as compared to actively managed funds because they require less management. Thus, the index fund ratio can range from less than 0.05% for some low-cost index funds to over 1% for some specialty index funds.

How to Evaluate Total Expense Ratios? 

Evaluating expense ratios can help you to make informed decisions about your investments. Here are a few ways to evaluate expense ratios:

• Industry Benchmarks: For example, the average Index fund expense ratio is generally lower than that of actively managed funds. Nifty BeES expense ratio is an index fund that tracks the Nifty 50 index and has a low expense ratio of around 0.10%.

• Comparing Expense Ratios Across Similar Investments: You should compare the expense ratios of similar investments to determine if they are paying more than necessary. 

• Considering the Fund’s Investment Strategy: The fund’s investment strategy should also be considered. For example, actively managed funds typically have higher expense ratios due to their strong history. 

What is a Good Expense Ratio?

There is no specific ratio that is universally considered “good”, as the appropriate expense ratio can vary depending on the investment strategy and the type of fund. Generally, a lower expense ratio is preferable, as it can help you to maximize returns. Thus, a higher ratio may be justified if the fund has a history of delivering higher returns.

In general, you should aim for a total expense ratio that is as low as possible while still aligning with your investment goals and strategy.

What are the Strategies to Minimize Expense Ratios? 

• Low-Cost Funds: Minimize expense ratios by investing in low-cost funds that have lower management fees and operating costs. 

• Passive Index Funds: By investing in passive index funds (such as the S&P 500), you can minimize their expense ratios and potentially achieve higher returns over the long term.

• Diversifying Across Asset Classes: You can minimize expense ratios by diversifying across different asset classes, such as stocks, bonds, and real estate. 

Expense Ratio Example 

Let’s assume that XYZ Asset Management Company manages a mutual fund that invests in a diversified portfolio of stocks. The expense ratio of the fund is 1.5%, which means that the company charges 1.5% of the total assets under management as fees for managing the fund.

For instance, if you invest ₹10,000 in this fund, the annual fee charged by the company would be ₹150 (i.e.1.5% of ₹10,000). This fee covers the cost of managing the fund, including research, trading, and administrative expenses.

To Wrap It Up…. 

To conclude, mutual fund and ETF returns are reduced by expense ratios to help cover operating and fund management costs. Expense ratios vary depending on investment strategy and trading activity of a fund. 

Therefore, understanding the expense ratio is crucial for you, if you’re looking to make informed investment decisions. By choosing low-cost funds, you can minimize fees and potentially increase their investment returns over the long term.