Mutual fund expense ratio – what it is, how it works

The mechanism of expense ratios in mutual funds is a befuddling topic for many investors. Over the years, questions associated with expense ratios have been among the most frequent that I have answered.

This essay is an attempt to answer questions on this topic in a patient and clear manner. But before we find out how it works, let’s understand a bit of what it is.

What is expense ratio in a mutual fund

When people invest in mutual funds, they outsource money management – that is, they entrust a fund manager from a mutual fund company (AMC) to manage their money for them. The fund manager and the AMC are rendering a service to the investor, and they charge for this service.

This charge manifests itself in the form of what is called an ‘expense ratio’. Truth be told, expense ratios are not unique to mutual funds. EVERY financial product that we purchase – from the simple fixed deposit to an insurance plan to stock market investing – involves somebody providing us with a service. And we ALWAYS pay for such services. In the case of fixed deposit, for example, this fee manifests itself when banks set the rates for the deposit based on their costs and rates at which they lend. 

In mutual funds and a few other products, these fees/charges are stated explicitly – like a price tag on a shirt. In many other products, such as deposits, these charges are implicit (or ‘hidden’, some may say).

The charge that is stated is in percentage terms – a percentage of the amount managed by a particular fund. So, if a fund says that it charges 1% expense ratio, and the fund manages assets worth Rs 100 crore (on an average during a year), then the AMC will charge, in a year, a total of Rs 1 crore. This is a very rough portrayal, just to illustrate how they are specified. We’ll look at the charging mechanism in detail later in the article.

How much is it

Mutual fund expense ratios are controlled or regulated by SEBI. The AMCs cannot charge whatever they want. One, SEBI specifies the maximum that each category of funds can charge. Two, SEBI defines caps based on the assets under management (AUM) of the fund as well. Expense ratios decline as a fund grows in size. 

For example, let’s take the case of equity funds – funds that manage stock portfolios for investors. The following table illustrates the maximum they are allowed to charge:

Source: SEBI | Securities and Exchange Board of India (Mutual Fund) (Fourth Amendment) Regulations, 2018. – Dated December 13, 2018

Please note that the charges are on a slab-basis, as the table above indicates. So, for an equity fund with an AUM of Rs 4000 crores, the expense ratio is not 1.6%, but 1.752%. Here’s how: the first Rs 500 crore will be charged 2.25%, the next Rs 250 crores – 2.00%, the next Rs 1,250 crores – 1.75%, and the final Rs 2, 000 crores – 1.6%. The weighted average of these comes to 1.752%.

Typically, most funds charge a little less than the maximum allowable expense. For example, here are some popular schemes, their AUM, and their expense ratios:

The important thing to note here is that all the mutual fund returns are specified AFTER taking into account the expense ratio. That is, if a fund says that it returned 12% compounded for 3 years, it is after the expenses. We’ll cover this more in the section on misconceptions below.

What goes into an expense ratio

For an investor, a fund specifies just one number for the expense ratio, or the technical name for it – the Total Expense Ratio (TER). However, this number includes a variety of costs and expenditures that the AMC incurs in managing the fund for its investors. In the USA, mutual funds are required to provide a top level break-up of the TER in the form of fund management fees, distribution fees, and other expenses. 

In India, we get just the total expense ratio. However, inside this one number are tucked in expenses that go under various categories. Some of these are:

1. Fund management – including the salary to the fund managers and their teams
2. Servicing – providing investor services like account statement, documentation etc.
3. Brokerage expenses – costs incurred to conduct trades in the portfolios
4. Registrar and Transfer expenses
5. Custodial expenses
6. Marketing expenses
7. Business expenses (rents, branches, infrastructure etc)
8. Taxes

Inside some or all of these, of course, is a profit for the AMC – it’s all a business at the end of the day!

There is one more wrinkle to how expense ratios are specified. We’ll come to that after we cover the importance of expense ratios in the first place.

Why people worry about expense ratios

Not just Indians, but people all over the world want value for money. We want good services, astute fund management, and handsome returns – and we want these at the lowest possible cost. 

There is nothing wrong with seeking that – it’s a competitive free market, and that’s how it’s supposed to work. Businesses compete with each other both on quality and cost.

For us, as investors, the less we pay, the more our returns. It’s as simple as that.

Let’s take an example. Suppose there are two funds that have the same portfolio (very unlikely, but just assume so for illustrative purposes) and the portfolio gains 12% in a year. If Fund A charges an expense ratio of 2% and Fund B charges an expense ratio of 1%, the returns in the hand of the investor would be 10% for Fund A (12% – 2%), and 11% for Fund B.

And this compounds every year that the investor is holding the funds. So, if we draw out this above imaginative pair of funds over a period of 5 years, you can see the returns to the investor as below (assuming another highly unlikely scenario of the portfolios returning the same 12% every year).

Amount of investment: Rs 100,000

As you can see, the difference in the returns add up quickly. And since mutual funds are often employed for very long periods of time – upwards of 10, 15 years of time – the difference can become substantial.

Of course, the point also to note here is that we have very artificially created two funds with the same portfolio that returns similarly every year. This scenario is next to impossible in reality (except in a very specific case which we will cover in the next section). 

Usually, funds are qualitatively different from one another and some funds return more than others because of quality of management. And therefore, a fund with a high expense ratio can still deliver much higher returns than a fund with a lower expense ratio because it has a better portfolio and strategy.

So if we always choose a fund with a lower expense ratio, we may end up with a poor quality fund. If we do that we will be losing out more on returns than we gained from a lower expense ratio. So, one cannot use the expense ratio alone as a determinant for choosing funds. Again, more on this in the section where we cover such misconceptions. 

The point of this section is to convey the fact that expense ratios do have a measurable impact on the profits that you earn from your online mutual fund investments. For that reason, they need to be part of the decision making process for choosing funds for investment. 

As always with mutual fund investing, this also is a balancing act. We cannot and should not ignore expense ratios. At the same time, we cannot go solely by expense ratios alone. We have to find quality funds and can use expense ratio as an arbiter to choose between very similar funds.

Regular vs Direct

We cannot cover the topic of expense ratios without touching on the differences between direct and regular plans of mutual funds.

For the uninitiated, every mutual fund scheme comes in two variants – one where you go through a distributor (who provides counsel and guides you for your investments) and one where you invest by yourself (or go through a fee-only advisor). 

In the former case (through a distributor), you would invest in what are called regular plans. In the case of doing it yourself, you would invest in what are called direct plans. The difference between the two plans is that when you invest in regular plans, the distributor gets paid a fraction of the expense ratio. With direct plans, since there is no distributor, that money does not get charged to the expense ratio.

Simply put, the expense ratios of direct plans are lower than those of regular plans. And this difference is directly attributable to the fee that goes to the distributor that facilitates the transaction for you.

The key thing to note here is that the comparison we made earlier between two funds with the same portfolios would be very valid for comparing the direct and regular plan variants of the SAME scheme. Which means, when an investor invests in the direct plan of a scheme for the same period of time as another investor who invests in the regular plan, the direct plan investor will, by design, make higher returns than the regular plan investor.

For more details on this, please refer to this article on choosing between direct and regular plans.

The mechanism of expense ratio

In many financial products, the cost of the product is either completely hidden (like FDs) or completely open (like brokerage amount in stock trading). That is, you know how much it is and how it gets charged, or you know neither.

Mutual fund expense ratio falls somewhere in between. You know how much it is, but it is not clear how it gets charged. For this reason, there is quite a bit of confusion about the mechanism of how the expense ratio works in funds. Let’s unravel the confusion.

There are few principles that go behind the mechanism of the functioning of expense ratios. They are:

1. It should be equitable – If you invest in a mutual fund scheme, your money is treated the same way as all other investors’ monies in the scheme. A person investing Rs 1 crore does not get special treatment for their investment in the portfolio. Similarly, the expense ratio is also uniformly charged to all the investors who hold units in the scheme.
2. The charged amount should be proportional to your period of investment – So far, when we mentioned mutual fund expense ratios, we specified them as an annual percentage. But what if you invest for 6 months? Or 3 years and 3 months? Should you pay the full 1 year fee in the former case and get charged for 4 years (or 3 years) in the latter case? No – you should be charged exactly for the amount of time your money is being managed by the fund house.
3. Not an explicit charge – This principle is more in the interest of the mutual fund company, than the investors. If a mutual fund company came to you at the end of the year and asked you to write a separate cheque for the expense ratio of the scheme you are investing in, how many people would do that? Can an AMC run their business that way? Unlikely. So, a third principle of functioning of expense ratio is that the charge be implicit – taken from the investment itself. Preferably in very small amounts that the investor does not notice 🙂

It was with these principles in mind that the mechanism of expense ratio was built.

Is there something that is common to all the investors of a scheme? Something that is tracked and updated on a daily basis? If there is something like that, it would be an ideal tool to use for implementing the expense ratio since it would satisfy the first two criteria above.

Yes, there is – it’s the NAV of a scheme. What is the NAV? It represents the value of the portfolio of a scheme at a unit level. Essentially, it is the total net value of the portfolio divided by the number of units in the scheme.

Every investor in a scheme sees the same NAV every day and it gets updated every business day of the scheme. So, if we can piggy-back the expense ratio on NAV, we can make it apply to all the investors equitably, and make sure it is applied only for the days that an investor holds units in a scheme.

And that is exactly how the mutual fund industry decided to implement the expense ratio of a scheme.

Every single day that the NAV is published, a tiny fraction is deducted from the NAV to account for the expense ratio. The amount thus deducted goes to the AMC every day, and gets used for various expenses required to maintain the scheme.

Let’s take a look at an example of how this works.

Example

Let’s look at an example with an imaginary scheme – Prime Flexi Cap – with easy-to-use numbers.

Prime Flexi Cap is an equity scheme with an expense ratio of 2.00%. It has a portfolio that is worth Rs 1000 crores. It has 1 lakh investors holding a total of 10 crore units (different investors holding different numbers of units).

Let’s assume this is the starting position of the Prime Flexi Cap fund. So, on the first day, before any expense gets charged, this would be the position:

Asset value: Rs 1000 crores

Number of units: 10 crore

NAV = 1000 crores divided by 10 crore = Rs 100

The portfolio (of stocks, since it is an equity fund), is in the market for a day, let’s say. At the end of the day, suppose the value of the portfolio goes to 1050 crores (a 5% appreciation). Let’s assume the number of units stays the same for the day.

Asset value: Rs 1050 crores

Number of units: 10 crore

NAV = 1050 crores divided by 10 crore = Rs 105

Now, the AMC needs to deduct ONE DAY’s worth of expense ratio from this fund. As we stated earlier, the expense ratio of this fund is 2%. Typically, there are 250 business days in a year (after accounting for weekends and holidays). So, one day’s expense ratio would be 

2% divided by 250 or 0.02/250 = 0.00008 = 0.008%

So, the NAV after this deduction would be 105 – (0.008% of 105) = 104.9916 = 104.992 (rounded off to 3 digits)

This is the NAV that would get published for this scheme at the end of the day. So, if you look at the value of the portfolio through this number, you will see that it is not Rs 1050 crores, but 1049.92 crores. The difference goes to the AMC for managing the scheme.

Thus, every day, the AMC makes money in their account for their expenses. And that money comes out of the scheme, which in turn comes from your investment.

This is how it works.

Now, you can see that this method is indeed equitable (because the same NAV applies to all the investors), applies in proportion to the number of days you are investing in a scheme (the amount is deducted a bit every day), and is implicit. The deduction happens in tiny fractions every day. Of course, when these tiny fractions are applied on large portfolios, it would turn out to be huge numbers. For example, if you revisit the table above, you will see that a single scheme – HDFC Hybrid Equity fund – takes over Rs 200 crores a year in expenses!

Misconceptions about expense ratios

When there is confusion about a concept, especially in the financial domain, people start assuming things about the concept and perpetuate their assumptions as facts. The mind rebels against lack of understanding a concept and fills it out with what seems logical.

When it comes to expense ratios, there are several misconceptions out there that need to be clarified.

1. They are charged when you redeem: No, they are not. They are charged on an everyday basis as we saw in the previous section. When you redeem from a scheme, apart from exit load and TDS (if either or both are applicable), nothing gets deducted from the investment.
2. We should subtract expenses when we calculate returns: Not true. All mutual fund returns are calculated after considering expense ratios. Returns are calculated based on NAV, and as we saw earlier, NAV is published after expense ratio deduction.
3. Expense gets charged only when the scheme does well: Not.true.at.all. Regardless of whether the scheme is moving up or down, the expense ratio keeps getting charged.
4. We should always choose funds with lower expense ratios: Not a good idea. We should choose funds based on their quality and potential to perform. If we go just by expense ratio, we will likely end up with poor quality funds that will cost us more than the amount saved by the lower expense ratio.
5. Expense ratios are the same for all funds in an AMC: Not true. Every fund in every AMC has its own published expense ratio. 
6. Direct plans have a lower expense ratio, so they are always better: True for the most part, but it still bears repeating that fund quality should be the primary criterion. Also, some categories of funds have higher direct vs regular expense ratio differential than other categories. Please read this article for an exploration of this topic.
7. Expense ratio is a fixed percentage: Not true, expenses are charged to the scheme based on actual charges incurred by the AMC, and could vary over a period of time. What you see as the expense ratio is the number for a particular past period of time. Like performance, past numbers will not always be future numbers.

Summary

Expense ratios are important for every investor to understand, observe, evaluate, and make part of their mutual fund investment decisions. It is not the sole or even the most important criteria to base your fund choices on, but no fund choice should be made without considering it. Understanding how expense ratio works, how it is calculated, charged, and how to interpret returns in the context of expense ratios is something that investors need to know and be aware of to make informed decisions.