For many Indian investors, mutual funds have grown in popularity as an investing choice. However, it’s crucial to comprehend expense ratio before making a mutual fund investment. This blog will define cost ratio, outline its components, and discuss why it’s a crucial consideration for investors choosing mutual funds.
Understanding Expense Ratio in Mutual Funds
A mutual fund invests the money it receives from several investors in stocks, bonds, and other securities. businesses that administer mutual fund schemes are known as asset management businesses, and their services are paid for with fees. This charge is included in a scheme’s expense ratio. Essentially, the expense ratio calculates the entire yearly operating costs that investors pay for any fund for instance if you own a Nippon mutual fund. Let’s look at the essential elements and importance of the expense ratio for investors in mutual funds.
What Does Expense Ratio Include?
The expense ratio of a mutual fund includes:
Investment Management Fees – Fees charged by the fund manager for managing the fund’s investments. This is usually the biggest component of expense ratio.
Marketing & Distribution Costs – Expenses towards marketing and distribution of the mutual fund schemes.
Administrative Fees – Costs for record-keeping, accounting, auditing and maintaining investor accounts.
Custodian Fees – Fees paid to the custodian for safekeeping the holdings of the mutual fund schemes.
Other Expenses – Registrar charges, printing, legal fees etc.
The expense ratio is usually expressed as a percentage of the total assets under management of the mutual fund scheme. All these operational expenses are accrued daily and charged to the fund.
Why Should Investors Care About Expense Ratio?
The expense ratio directly impacts returns earned by an investor in a mutual fund. A higher expense ratio means more fees are charged to the investor, eating into the fund’s actual returns. Therefore, the expense ratio is an important factor to consider when selecting a mutual fund scheme. Let’s understand its significance in more detail:
Reflects Cost of Investing – The expense ratio allows an investor to truly assess the costs involved in investing in a particular mutual fund. The actual returns realised are after accounting for these expenses.
Impacts Compounding – Even a small difference in expense ratio can result in a big difference in earnings over long term, due to the power of compounding. Opting for low cost funds enhances wealth creation potential.
Indicator of Efficiency – Generally, a lower expense ratio indicates greater operational efficiency and cost management by the asset management company.
Allows Comparison – The expense ratio makes it easier for investors to compare mutual funds before making investment decisions.
What is a Good Expense Ratio?
Typically, an expense ratio below 1% is considered good for equity funds whereas it is lower for debt funds. Index funds tend to have the lowest expense ratios. However, an investor must assess the ratio in conjunction with other factors like fund category, scheme quality, returns generated etc. A higher expense ratio may be justified if a fund provides significantly higher returns over the long run.
Types of Mutual Fund Fees
In addition to expense ratio which is charged annually, some mutual funds may also charge the following one-time fees:
Exit Load – Fees on redemption before a specific period. Helps discourage short term withdrawals.
Entry Load – Charged on investment amounts. SEBI has banned entry loads in 2009.
Switching Fee – Charged when switching from one fund to another within the same AMC.
Conclusion
Now you know what is expense ratio in mutual funds, a crucial step in the process of choosing a fund for an investor should be analysing the cost ratios of mutual fund schemes. Over time, a cost-effective portfolio can improve wealth creation. But when it comes to investing, a low-cost ratio shouldn’t be the only consideration. For a portfolio to yield strong returns, the quality of the underlying investments is more important. When making investing selections, an investor has to consider the cost ratio together with other factors such as fund category, investment strategy, holdings in the portfolio, fund management track record, etc.
