Mutual Fund Expense Ratio: Meaning, Calculation, Formula, Performance & Return

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Investors who have invested in mutual funds might know the importance of expense ratio to make a great investment decision. The expense ratio is calculated to know the amount you must pay in a year to own a fund. Even though higher cost is associated with higher returns (when calculated on a percentage basis), it is not true in most cases. An investor must make a careful decision so that the expense ratio does not cut off the return on investments. This post will help you know more about the mutual fund expense ratio.

Mutual Fund Expense Ratio Basics

The cost of owning a mutual fund is called the expense ratio. There are various benefits to owning a fund, and investors need to pay a fee in the form of an expense ratio. It is similar to a management fee you pay to own a property. This charge is levied on an investor annually if the fund is held for a year. By understanding the expense ratio, you can measure the cost efficiency of your fund. For instance, if the expense ratio for a fund you invested in is 0.25%. With this, you can calculate that you should pay ₹25 for a fund value of ₹10,000 annually.

Expense Ratios and Fund Performance

Understanding the impact of expense ratios on mutual fund performance and returns is essential for investors. These ratios, like operational costs, significantly impact a fund's effectiveness. Low-cost index funds typically aim to mirror the performance of a specific market index, such as the Nifty Midcap index. These funds are known for their passive strategy, offering market exposure while keeping expenses low. On the other hand, actively managed funds involve fund managers making strategic decisions to outdo the market, potentially resulting in higher returns but often with higher associated costs.

How Do Expense Ratios Affect Returns?

Mutual fund expense ratios matter because they directly influence how much money you make from your investments. Simply put, they're like fees charged by investment funds. When these fees are low, you can keep more of your profits. Investments with low expense ratios run on a minimal budget, leaving you with a higher return on what you make. Think of it as cutting excessive expenses from your finances. Moreover, this is important for long-term investors, as small fees could be compounded and impact your wealth. Understanding the expense ratio lets you make better decisions and earn more returns by minimising the fees.

How is an Expense Ratio Calculated?

The formula to calculate the mutual fund expense ratio is:

Expense ratio (%) = Total annual fees/Total Investment

The fees charged to manage the fund are directly related to the investment. The expense ratio also increases if the active management required is high for a fund. The fees are substantially low for funds requiring passive management. Index funds are passively managed and have a low expense ratio. Other than the expense ratio, buying and selling funds involve many other charges like auditing expenses, accounting expenses, taxes and legal fees. These charges keep varying throughout maturity, but the expense ratio is relatively stable from one year to another.

How to Find Funds with Low Expense Ratios?

Now that you know the funds with higher expense ratios are costly, look for ones with low expense ratios. Investors who are beginners in the mutual fund market should select funds with less management cost. Below are a few things to consider while selecting a fund with a low expense ratio.

Funds based on indexes like the Nifty 50 tend to have the lowest expense ratio.
Index funds generally have a low expense ratio as they are passively managed.
Even though index funds are cheaper than ETFs, in comparison to mutual funds, ETFs have more benefits, including high tax efficiency and zero brokerage.

Conclusion

Now that we have discussed the effect of the expense ratio on your portfolio, the best option is to choose a low-cost investment. Many investors think the higher the cost of funds, the higher the returns. However, there is a lot of evidence to prove that many low-cost funds are offering attractive interests. In many cases, these low-cost funds offer more than actively managed funds. Keep the tips provided above to invest in a fund with a low expense ratio. Kotak Mutual Funds platform offers various mutual fund options you can choose from as per your financial objectives or preferences.

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Frequently Asked Questions (FAQs)

Q: How important is the expense ratio in mutual funds?

The expense ratio refers to the fee charged to manage a fund. If a fund is actively managed, the expense ratio is usually higher. As the expense ratio is deducted from overall returns, it is important to choose funds carefully.

Q: What is the lowest expense ratio in mutual funds?

Typically, the average rate of expense ratio is between 0.50% to 1.50%. However, the expense ratio of index funds or ETFs can be as low as 0.21% or zero in some cases.

Q: What are zero expense ratio funds?

Zero expense ratio funds are those where no fee is charged to the investor to manage the funds. These are usually Index funds or ETFs as they don't involve many expenses.

Q: Is the 0.8 expense ratio good?

The ideal expense ratio depends on the various factors. If the returns are not too high, the 0.8 expense ratio can be considered high for a few funds. Usually, an expense ratio above 1% is considered high.

Q: Is the 1 expense ratio too high?

Yes, depending on the type of fund. Some mutual funds have high returns in the long term, which is why investors select them. However, on average, the expense ratio of 1% is considered high. Additionally, the expense ratio also depends on Asset Under Management (AUM)where a higher AUM will have a lower expense ratio and vice versa.