Expense ratio is the annual maintenance charge levied by mutual fund for managing the fund. It is expressed as a percentage. If a mutual fund scheme has expense ratio of 0.5, it means that the annual maintenance charge would be 0.5% of market value of investment.
Let’s understand this with an example. Investor A has invested 1 Lakh rupees in a mutual fund scheme. If the expense ratio of mutual fund scheme is 0.5, then 0.5% of 1 lakh i.e., 500 rupees will be charged by the AMC for managing the fund. Suppose there is 20% gain on the investment next year. The market value of investment next year is Rs. 1.2 lakhs. Then, the charge levied next year will be 0.5% of 1.2 lakhs i.e., 600 rupees.
The above example tries to explain the concept in a simple way. Usually, the expense ratio is calculated everyday on prorated basis.
Lower the expense ratio, more is the money invested on behalf of investor by mutual fund and vice versa.
As per SEBI guideline, mutual funds have restrictions to charge expense ratio based on AUM as below:
| Assets Under Management (AUM) | Maximum TER as a percentage of daily net assets | |
| TER for Equity funds | TER for Debt funds | |
| On the first Rs. 500 crores | 2.25% | 2.00% |
| On the next Rs. 250 crores | 2.00% | 1.75% |
| On the next Rs. 1,250 crores | 1.75% | 1.50% |
| On the next Rs. 3,000 crores | 1.60% | 1.35% |
| On the next Rs. 5,000 crores | 1.50% | 1.25% |
| On the next Rs. 40,000 crores | Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets or part thereof. | Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets or part thereof. |
| Above Rs. 50,000 crores | 1.05% | 0.80% |
Should expense ratio be an important parameter for mutual fund selection?
From the above explanation, it is clear that higher the expense ratio, higher is the charge levied for managing the fund. But paying a higher charge is not always bad. Suppose you have invested in 2 mid cap mutual fund schemes for 10 years, let’s say fund 1 and fund 2. Fund 1 has expense ratio of 0.5, and Fund 2 has expense ratio of 0.7 throughout your investment duration. At the end of 10th year, CAGR of Fund 1 is 15% and CAGR of Fund 2 is 18%. In this case, investing in Fund 2 is a better decision even though the expense ratio is higher for Fund 2. This example is based on assumption as the expense ratio of mutual fund would change from time to time.
Let’s take a mutual fund category offered by 30 AMCs for investment. The expense ratio is in the range of 0.3 to 1.25 for all the mutual funds in the category. It is not necessary that mutual fund with 0.3 expense ratio will be the best performer, and fund with 1.25 expense ratio will be the worst performer. But it is better not to opt for mutual fund with highest expense ratio in the category as the money available for investment after the expense ratio charged reduces, and it is a large amount in long run. In this case, it might be a good decision to choose a mutual fund scheme with expense ratio in between 0.3 to 0.8, though expense ratio should not be the only parameter for mutual fund selection.
Please note that this blog is written considering investment is done in direct plan and not regular plan. In a regular plan, the expense ratios are higher as it also includes the charge of agent involved.