What is Expense Ratio?
Updated on 24 Feb 2020
Look up any ETF or investment strategy, and you are sure to see the term ‘Expense Ratio’ mentioned alongside. This is an important factor in calculating the total fees paid to your wealth manager. Learn more!
What is Expense Ratio?
The most basic definition of expense ratio is that it is the annual fee that all funds or exchange-traded funds (ETFs) charge their shareholders. In other words, you can think of it as a ratio per unit cost of managing a fund. To get help you get good returns from your investment, the asset manager takes various steps to get the best possible result.
This requires expenses. The asset manager and a team of analysts come up with various formulas to detect an annual fee that the shareholders have to pay as the maintenance cost.
The process involves reallocation of your investments in the right funds, management under the AUM (assets under management) and then advertisements of the same to garner maximum attention in the market and thus improve the worth of the shares. The other aspects that are involved in this process are securities to incur the objectives of the scheme, registering and transfer, custodian, audit fees and various other legal fees.
The expense ratio depends on the size of the funds. If they are small then the expense ratio or fee is high and when the funds are higher and bigger, the expense ratio should ideally drop considerably.
Components of expense ratio
When it comes to expense ratio to be levied by mutual fund investors, the funds do it on a daily basis. However, this is not the case with other mega investors as they only get to know about the expense once every 6 months. Since expense ratio can cover up a major chunk of your returns, it is important that you know about it in depth. Generally, the expense ratio can be divided into three broad categories.
- Management Fees – Management fees is basically the fees required to formulate a plan on how to use your investments. Such decisions require personnel with high levels of skill and experience and naturally a fee has to be paid to avail such services. In most cases, it is not more than 1% of the fund assets.
- Administrative Fees – This is the second step of managing your funds, which includes customer support, services, information emails and all the other communication you need to have a better understanding of the running of your investments.
- 12-1b Distribution Fees – This is the fees that is used to promote or publicize your assets to attract more traction.
All three fee structures are calculated with one year as the time period and then this amount if cut from the assets of the investment in the name of expense ratio.
Types of Expense Ratio
- Annual Gross Expense Ratio
- Annual Net Expense Ratio
- Prospectus Gross Ratio
- Prospectus Net Expense Ratio
Implications of Expense Ratio
The implications of Expense Ratio are major when it comes to higher expense ratios. The expense ratio is more when the funds or assets are not that high, leading to less profitability and the profit increase when you have larger funds. As a result, the amount associated with the expense ratio becomes more important in cases where there are moderate to lesser yields.
Another major implication of expense ratio comes when you need to differentiate between actively managed and passively managed funds. In case of an actively managed equity funds, the fund manager can create a big alpha but that is justifiable in a way because of the higher returns. However, if you find a wide divergence between the returns of your fund and index funds, then it is time for you to move on and make a switch.
Changes in Expense Ratio
To understand the changes in expense ratio, you first need to understand the difference between fixed and variable expenses. A variable expense like management fees is variable because it depends on the amount of assets. Therefore, it usually has a fixed percentage of 0.75% irrespective of the size of the assets.
However, a fixed variable like rent or an audit fee is something that has a fixed amount to be paid and therefore has varied percentages of the total asset. These two factors are the major determinants in understanding how a change occurs in expense ratio.
Expense Ratio Limit by SEBI
As per limits specified in SEBI Mutual Funds Regulations, every expense of an AMC must be managed under Regulation 52. The Total Expense Ratio (TER) should not be more than 2.5% for the first Rs. 100 Crores of average weekly total net assets, 2.25% for the next Rs. 300 crores and 2% for the next Rs 300 crore and 1.75% for the remaining AUM. The limit for debt funds is 2.25% on top of which SEBI allows all mutual funds to charge 30 basis points as an incentive to break into tier 2 areas.
An expense ratio is something that is unavoidable and therefore there is no need to think badly of it. In fact, you should just think that if you do not pay this expense ratio then it would be almost impossible for your assets to grow, hence making it a necessity rather than a liability.
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