Making your money work for you is essential in the present times. Due to the impact of inflation, the real value of the money drops significantly. It is, therefore, crucial to ensure that your money generates returns which are more than the inflation rate. Therefore, it is important for you to find suitable investment avenues to park your spare funds and create a corpus for your future requirements. One such investment option that has gained extreme popularity in the present times is Mutual Funds.
Importance of Mutual Fund Management Fees (Expense Ratio)
The quantum of mutual fund expense ratio is significant for investors as it has a direct impact on the net profits generated from the investment. In order to calculate the fund fees, you need to divide the total value of a fund by the total fund fees that are charged from the investor. The fund fees comprise of both the operating expenses and the fund management charges.
Mutual Fund Expense Ratio = (Operating expenses of the fund)/(Average Asset under Management)
Components of Expense Ratio
Expense ratio essentially includes all the charges that have to be paid by an investor for seamless management of the mutual fund portfolio. Though these expenses are charged from the investor on a daily basis, the exact amount is revealed only at the end of the month.
Three major components of expense ratio are:
Management fees: This fee is used to compensate the fund managers for the services provided by them.
Distribution fees: This fee is used to compensate the distributor for the services provided by them.
Administration fees: This fee is charged for expenses incurred on the administration part such as customer support, record management, etc.
Expense ratio is usually charged as a percentage of the assets under management of the mutual fund and has a direct impact on the returns you generate from the scheme. In simple words, the higher the expense ratio, the lower are the returns for the investors. The expense ratio has to be set by the fund as per the guidelines of SEBI. Presently, the expense ratio is capped at 1.05% for equity funds with AUM greater than Rs 50,000 crore. The expense ratio of index funds and exchange-traded funds (ETFs) has been capped at 1%. The expense ratio of actively managed funds is significantly higher than that of index funds.
Importance of Expense Ratio
Many times, investors do not pay heed to the expense ratio while deciding on a mutual fund. But this approach could be detrimental to your interests. A slight change in the expense ratio can make a significant difference to the returns that you generate from your investment.
For instance, consider two mutual funds with an average annual return of 10% and an expense ratio of 1% and 2% respectively. You might think that the difference of 1% is not too significant, but you must know that the expense ratio is based on the value of assets under management and not on the profits earned.
Now, if you invest Rs. 2,00,000/- in the respective mutual funds, you will generate a return of Rs. 20,000/- before the expenses. Now, for the fund with a 1% expense ratio, you will be paying expenses of Rs. 2,000/-, thereby your returns would be Rs. 18,000/-. While for the fund with a 2% expense ratio, you will be paying Rs. 4,000/- as expenses, thereby generating lesser returns of Rs. 16,000/- Now you can see that only a 1% difference in the expense ratio results in more than 10% difference in the net profits.
Summing it up
The importance of expense ratio is clear now, but it should not be the only factor to be considered. Several other important factors include the experience of the fund manager, total returns generated by the fund over the last five years, the profile of the investment team and more. Making an informed decision is crucial to the growth of your investment, and you having a financially secured future.