Mutual Funds Day 15: Expense Ratio
If you know what stock to buy and hold for life — then your job is super easy. Everyone else might have to go through countless buying and selling to find the perfect stock. Each transaction comes with charges & taxes. We are the rarest of the countries that even charge taxes for losses.
Mutual funds on the other hand are exempt from income taxes or charges. The Fund manager can buy/sell stocks also known as Churn as per requirements and end up not paying taxes. The charges are also minimal as most AMCs do not pay huge brokerage or per-order fees.
Mutual Funds pool money from many investors and then assign fund managers to handle the investments diligently. The salary of these fund managers, fees, etc is split evenly as a percentage of fund value to the investors. This handling cost is known as Expense Ratio.
There are 3 main expense heads for any AMC
- Management Salary, Incentives.
- Administrative Charges.
- Distribution or Marketing Expenses.
Usually, the management fees, salaries of fund managers, etc. will comprise the major chunk of the Expense Ratio. The performance of a MF is directly related to the expertise of the Fund Manager. And a good fund manager will have a higher salary & incentive. So logically the MF that outperforms the market should have a higher expense ratio.
The bookkeeping, customer call center expenses, compliance expenses, and other statutory charges will be marked under the administrative charges head.
Distribution expenses are paid to intermediaries for promoting the MF. Usually, the AMCs cannot hire celebrities for advertisements due to the cost factor. Instead, they will fix an incentive model for brokers or investment advisors and pay them a trail commission.
If the expense ratio = 2%, what it means is that AMC will charge a fee of 2% of your total funds per year as its expenses. If your fund value = Rs100000 the AMC will charge Rs2000 per year. Ideally, the NAV published will be after deducting the expenses so you do not pay anything from our pocket explicitly.
A higher expense ratio means the charges you are paying will be higher. Any cost is a drag on total performance, so you should always find MFs with lower expense ratios. Meanwhile selecting MFs just by looking at ER won’t give you better returns. Let us look at an example
Selecting an MF plan with a higher ROI will offset a higher ER in the long run. It is always recommended to get help from your Financial Advisor to select the right fund for you.
In Chapter 10, we learned about Active vs Passive MFs. All Passive MFs will have lower ER as the AMC can save on active fund management fees.
https://viswaram.com/mutual-funds-day-10-active-versus-passive-funds-5c190660186a
TER (Total Expense Ratio)
When you divide the sum of all costs/expenses by the total assets you get the TER. SEBI under Regulation 52 has set limits to the TER an AMC can charge from its clients.
All MFs are required to disclose their TER daily — on their website as well as on AMFI’s website.
https://viswaram.com/mutual-funds-day-10-active-versus-passive-funds-5c190660186a
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