Expense Ratios: A Guide for Mutual Fund and ETF Investors

Have you seen or talked with experienced mutual fund or ETF investors? They often compare different collective investment schemes based on Net Asset Value (NAV), expense ratio, Asset Under Management (AUM), and other factors. Beginners or new investors must know these terms to make better decisions and protect their trading capital. Let us discuss the expense ratio in detail in this blog.

What is the Expense Ratio?

The expense ratio is the maintenance charge that the Asset Management Companies or the fund provider applies. It is usually expressed as a percentage of the total value of assets in a collective investment scheme. Investors have to pay it once a year in most cases. 

The mutual fund provider or the AMC has to incur advertisement costs, management fees, allocation charges, and other expenses. They recover these costs by charging them from their investors. A small mutual fund will allocate funds for management and other costs. The relative expense ratio can be higher for a small mutual fund. However, it is usually low when compared to the total value of a large mutual fund.

How Expense Ratios Work?

The AMC or the fund provider will start by calculating the operational expenses for a mutual fund scheme. Operational expenses will include the fund manager’s fee, advertisement costs, fund commentary costs, and other charges. The fund provider must recover these costs from investors to successfully manage the mutual fund or ETF scheme. It is where the expense ratio comes into the picture for recovering operational costs.

The AMC will divide the total operational expenses by the average value of the assets to evaluate this metric. Investors are notified about it in advance. Investors must pay the pre-determined amount once a year to the AMC or fund provider. Let us take an example for a clear understanding. Let us say a mutual fund scheme has a ratio of 1, and you invest INR 1,000. In this case, you will pay INR 10 (1% of 1000) to the mutual fund provider.

What’s a Good Expense Ratio?

Many new investors struggle to grasp fee structures and end up in higher-cost funds. Remember, lower fees translate to higher final returns, but it’s not the only puzzle piece. Performance history, net asset value (NAV), assets under management (AUM), and other factors all play a role in choosing the right fund.

Comparing expense ratios of different funds is crucial. Fund managers and companies disclose these fees, allowing you to research online before investing. As per statistics, the ratio has declined over the years. For instance, the average ratio for stock mutual funds was 0.99% in 2000. However, for equity mutual funds in 2022, it is around 0.68%.

Investors must look for mutual fund schemes with an expense ratio between 0.5% and 0.75%. It will allow them to pay fewer charges to the AMC or fund provider and keep most of their returns.

What are the Components of Expense Ratio?

Now that you understand the expense ratio meaning, let us discuss its components. It has several components that are revealed to the public at regular intervals. The management fee is a major component of a mutual fund . The fund manager for a mutual fund scheme will make decisions on behalf of the investors.

Besides the management fee, the AMC or fund provider can charge a maintenance fee. AMC has to incur costs for managing the records of investors, providing customer/chat support, and other purposes. 

The AMC or fund provider creates a base of information for existing and new investors. It also launches fund commentaries at regular intervals for existing and new investors. All these expenses are added to these ratios. It will also consist of the entry and exit loads. Entry load is the amount paid by the investors to join a mutual fund scheme, while exit load is the charge paid for leaving the scheme.

How Do Expense Ratios Affect Returns?

The expense ratio in mutual funds can impact your returns. It is crucial to note that it is deducted from the mutual fund’s assets. It means the AMC or fund provider will deduct the costs from the fund’s total returns. Once the charges are deducted, the returns are distributed among investors. In short, you do not pay the charges out of your investments like a fee. It is an ongoing charge that will impact the overall return in the mutual fund scheme. For the same rationale, investors prefer mutual fund schemes with lower expenses, as they will get higher returns. A higher expense ratio will reduce the mutual fund’s total assets, thus reducing the returns for investors.

How is an Expense Ratio Calculated?

One can easily calculate the expense ratio for a mutual fund or ETF based on this formula:

Expense Ratio = Total Fund Expenses / Total Fund Assets

You must add maintenance, management, advertisement, and other expenses for a collective investment scheme. Divide the sum by the total assets, and you will have the charges. Luckily, you don’t have to be involved in calculating before investing in a mutual fund or Exchange-Traded Funds .

How to Find Funds with Low Expense Ratios?

Are you looking for mutual funds and ETFs with a lower expense ratio? Here’s how to find funds with lower charges:

• ETFs usually have a lower expense than mutual fund schemes. Since ETFs only track the performance of specific market indices, their ratios are low. The costs associated with the management of an ETF are usually low.

• Mutual funds are of several types. Index mutual funds have a lower expense ratio. Like ETFs, index mutual funds also track the performance of specific market indices. Some index mutual funds might even be cheaper than ETFs.

• Many mutual funds and ETFs based on popular market indices have low charges. You can search for such mutual funds and ETFs online.

• You can use a trading platform to find mutual funds with low expense ratios. You can apply filters or screeners to find funds with low charges.

Expense Ratio Vs. Management Fees

Some of you might be confused between the expense ratio and management fees for a fund. Here are the dissimilarities between the two in the context of collective investment schemes:

Conclusion

Mutual fund and ETF investors must consider the expense ratio before deciding. For a fund, it is the total operational and administrative costs. It is charged as a percentage of the fund’s total assets. Usually, ETFs and index mutual funds have a lower ratio than other collective investment schemes. Search for schemes with lower expense ratios now!

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