KNOWLEDGE CENTRE Mutual Fund Basics / What is Expense Ratio?

What is Expense Ratio?

Know What is Expense Ratio

Mutual fund investment can help you earn a good enough sum of money. But to have a better understanding of the actual amount that you would earn, it is important to know what is expense ratio.

What is Expense Ratio?

All mutual funds and exchange-traded funds (ETFs) charge a certain ratio to investors for covering the annual operating expenses. Some of these include operating costs, administrative and management fees, distribution fees, and other costs. It is often a certain percent of the fund’s average net assets.

Some mutual fund charges are not included in this expense ratio including brokerage costs and transaction fees along with deferred or initial sales charges. This ratio is reduced from the fund’s net assets accrues on a daily basis.

You may ask what is expense ratio for a smaller fund. If the fund’s assets are small, this ratio may be significantly higher. This is because all the aforementioned expenses are reduced from a smaller asset base. On the other hand, as the fund’s assets increase, the ratio must reduce because it is spread over a wider base.

There are four types of expense ratios:

  1. Annual Gross Expense Ratio
  2. Annual net expense ratio
  3. Prospectus gross expense ratio
  4. Prospectus net expense ratio

Annual gross expense ratio

The annual gross ratio is the percent paid from the assets towards operating expenses, management fees, and interest. It generally includes the following fees:

• Dividends and interest on borrowed securities
• Accounting and administrator
• Board of directors
• Custodial
• Advisor and audit
• Distribution
• Legal and professional
• Organizational
• Shareholder reporting
• Registration
• Sub-advisor
• Transfer agency

However, this ratio does not reflect investor sales charges and brokerage costs. In addition, it does not reflect any fee waivers that may be effective from time to time. Also known as the ‘audited gross expense ratio’, it is often available in the fund’s annual reports.

Annual net expense ratio

This ratio reflects the percent of the fund’s assets paid towards management fees and operating expenses. It includes all the fees within the annual gross ratio. However, the difference is that the annual net ratio reflects the waiver of fees that are applicable from time to time. However, the dividends on borrowed securities and interest are excluded from this ratio. Also known as, the ‘audited ratio’, this information is also available in the audited reports.

Prospectus gross expense ratio

This ratio reflects the percentage of the fund’s assets towards management fees and operational expenses in addition to the other expenses. However, investor sales charges and brokerage expenses are excluded. Additionally, it does not reflect any applicable fee waivers. Also referred to as ‘total annual fund operating ratio’, it is available from the fund’s latest prospectus. This ratio shows any material changes occurring in the fund’s expense structure during the current period. In contrast, the annual report ratio shows the actual fees that are charged in a fiscal year.

Prospectus net expense ratio

It includes and excludes all the expenses within the prospectus gross ratio. The core difference l is that the net ratio includes fees waivers that may be applicable. This ratio is also known as ‘total annual fund operating ratio net of reimbursements’ and is available in the fund’s most recent prospectus.

Now that you know what is expense ratio, here are four ways you may use to determine a fund’s ratio.

  1. Financial news websites:
    Several websites provide this information for mutual funds and ETFs
  2. News journals:
    Financial newspapers and magazines offer details on different funds’ expense ratio
  3. Prospectus:
    Most funds provide this information in its prospectus, which is emailed to existing holders or is available from the website
  4. Fund screeners:
    Several ETF and mutual fund screeners are available on the Internet allowing you to check the ratio either for a group or category

How important is the expense ratio?

You may invest in mutual funds without knowing about the expenses incurred by the asset management companies (AMCs). Some of these include selling and promotional expenses, registrar fees, agent commissions, and fund management fees.

Do you know who pays for all these expenses? Well, it is paid by investors like you. This ratio is deducted from the Net Asset Value (NAV) on a daily basis. This effectively reduces your actual returns from investing in mutual funds. Although the reduction may appear minor and does not significantly, affect your returns in the short-term. However, if you remain invested for 10 or 20 years, the cumulative reduction will work to a significant amount. Thankfully, the Securities and Exchange Board of India (SEBI) puts a limit on the maximum ratio that may be levied by AMCs. Equity funds may levy up to 2.5% while debt funds are restricted to 2.25% of the total assets.

A higher ratio is harmful in the long-term. Therefore, to avoid falling prey to such hidden charges, consider using ARQ. This smart investment engine offers machine-based recommendations to you free from all human bias after analyzing over a billion data points.

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