An introduction to the term "Expense ratio".

Wednesday, April 11, 2018 ORO Wealth 0 Comments





Did you know expense ratio actually impacts your returns from mutual funds?

We all have come across the term expense ratio of varied percentage levied on our investments but we have seldom put in efforts to flip through the fund document or the web to understand the mechanism behind expense ratio and the potential impact it could have on our own investments. We, at ORO, believe it is a good time to touch base this topic that is gaining much importance since the SEBI circular has put a cap on the expense ratio.

What is an expense ratio?

An investor just buys and sells mutual funds but in the process of doing so, there are many expenses that are incurred by the asset management company in the background. Some of the expenses that are generally incurred include fund management fees (salaries of fund managers, and research team), commission to distributors, registrar fees, trading cost (brokerage for buying and selling of the securities), administrative expense (sending fund statement, etc.), and marketing fees (advertisement, media etc.). As per the recent SEBI guidelines, the maximum expense ratio that can be incurred by an equity fund is capped at 2.5% and for a debt fund, it is 2.25%.

Who pays the expense?

This expense is ultimately borne by the investors like us and the amount is deducted from the investments on daily basis. Thus the NAV reported for funds on a daily basis is net of the expense ratio.

Let us understand this with an example:

Amount invested
Rs 1,00,000
Number of units allocated
1
Net Asset Value (NAV)
Rs 1,00,000
Expense ratio cap
2%
Date of investment
11-Apr-2018
1-day return (as on 12-Apr-2018)
0.5% = Rs 500 on the invested amount
Current value
Rs 1,00,500
Daily expense to be paid
(2%/365) of Rs 1,00,500 =  Rs 5.5
Final value
Initial amount + (profit/loss) – expense ratio
Rs 1,00,000 + Rs 500 – Rs 5.5 = Rs 1,00,494.50

As seen from the computation above, the final one-day growth after expense ratio is 0.49% instead of 0.50%. One of the questions that arise now is “Does this small deduction makes any difference to the fund returns?

The answer is neither Yes nor No as the answer is a function of time horizon. If investment horizon is less than 12 months, then the expense ratio doesn't really make much difference. However, if the investment horizon is long-term of 5-7 years or more, this small deduction will certainly make a huge impact given the compounding impact that happens to this amount.

Expense Ratio – Impact Explained

Let us explain you the importance of expense ratio clearly with the help of example where we have Fund A which doesn't have any expense and we have Fund B, C, and D with varying expense ratio but similar returns to Fund A.


A
B
C
D
Monthly
10,000
10,000
10,000
10,000
Tenure
10 years
10 years
10 years
10 years
Return (%)
12
12
12
12
Invested amount (Rs)
12,00,000
12,00,000
12,00,000
12,00,000
Expense ratio
0%
0.5%
1%
2%
Final Amount
23,58,550
22,84,135
22,12,146
20,75,144
Difference in profit when compared with Fund A
--
74,415
1,46,404
2,83,406

How does the fund determine expense ratio?

A fund does not just use dart mechanism to determine any random figure as the expense ratio. The expense ratio is the actual cost that is incurred by the fund house towards a fund. Once the expenses are added up, the percentage of the fund’s AUM representing the expense is called expense ratio. With tightening guidelines from the market regulator SEBI, fund houses cannot charge any random expense. The regulator has specified the expenses that can be charged and has put a cap on the spend. In order to ensure, a fair treatment is done for all the investors and also to ensure liquidity is high, the fund house does not charge these expenses at once but spread it over a period 365/366 days thereby compounding on daily basis. Also, to ensure a high degree of transparency, the expense ratio is published regularly by the found house and is made available on the website of the fund house for public access.

Some points to ponder:
  • Expenses are charged to the fund as a whole and is irrespective of the number of transactions made by the investors in the fund or the analyst team while buying or selling of securities.
  • At the time of making an investment, the entire amount goes towards the purchase of units in the fund. However, the NAV computation from the 2nd day is net of the expense ratio.
  • These expenses are operational in nature and thus has been to incurred irrespective of fund performance.


Also,
Every fund has minimum two plans for investment – direct plan and regular plan. The regular plan comprises of distribution expenses paid out as commission to distributors, this results in comparatively higher expense ratio for regular plan compared to direct plan. 
(Refer chart below for Axis Long Term Equity Fund).
Source: ORO Wealth


Last but not the least, while an investor should always pay importance to fund performance, sustainability of returns, alpha generation, track record of fund manager, performance against category average and its peers, risk profile against category and peers etc. they should also give due consideration to expense ratio to understand the expenses incurred by the fund as these funds, when accumulated over a long-term, has the potential to grow and become sizeable.

Thus, it is advisable to switch to direct plan. Should you have any queries with respect to switching to direct plan, feel free to drop in a line at connect@orowealth.com and we'll be glad to assist you. 

You Might Also Like

0 comments: