You must have heard, “Mutual fund Sahi hain.” (Mutual funds are good.) But are they free? When you invest in a mutual fund, you might have thought that how does Mutual Funds charge you.
You don’t pay them separately. So, today, in this article, we will tell you what are expense ratios. How are they deducted? And how do they impact your returns?
What is Expense Ratio in Mutual Fund?
The charges which mutual funds charge to manage your fund are called expense ratios. You don’t need to pay this expense ratio separately.
But they are deducted from your NAV. NAV means net asset value. NAV is published daily.
Now you may be thinking about what is NAV. Just like a share has a price, Mutual Funds have units,which has NAV for example, if you are investing Rs. 10, if NAV of a fund is Rs. 10and if that NAV becomes 15. Then it means that you have earned50% returns. And this expense ratio is yearly charged on a daily basis.
Why Expense Ratio is Charged?
Now you may be thinking why this expense ratio is charged. To fund or to run any business, they incur some expenses. There are different components of expense ratio:-
- Fund Management Expenses
- Marketing and Distribution Expenses
- Legal and Audit Expenses
Fund Management Expenses
Your fund managers, your researchers,who choose stocks for you, who put them in your mutual fund after doing research, they are paid a fees. These are fund management expenses.
Marketing and Distribution Expenses
All the ads you see,”Mutual fund sahi hain,” You see the hoardings,ads on TV. Expenses are incurred for them.
Legal and Audit Expenses
It includes auditor fees, charges of legal advisors,it includes them all. Because, you have to followall the compliances of SEBI. If you break any regulations, you have to pay extra penaltyor extra charges.
Also Read :
What is the Total expense Ratio?
Hence, you have to pay these expenses. Combining all these,comes the total expense ratio. And this total expense ratio,according to the guidelines of SEBI, can be charged at a maximum of 2.5%.
Now we will tell you how expense ratios are deducted. For simple calculations, let’s assume Mutual Funds gives you no return So let’s assume you have invested Rs 50000 in a mutual fund and expense ratio is 2% So you must be thinking now that Rs 1000 will be deducted.
But it is not like that Your expense ratio is deducted daily from your invested amount So invested amount at Day 1 is Rs 50000 calculating with 2% you will divide it with 365 Day 1 expense ratio comes around Rs 2.73 when you will see your next day invested amount that will be around Rs 49997 So the Day 2 expense ratio will not be calculated at Rs 50000 but at Rs 49997 which comes around Rs 2.73 So continuing in the same manner, On Day 365 the amount will be Rs 2.685 So if you add each day expense ratio the total comes around Rs 990 and not Rs 1000.
So this is a simple example where we have demonstrated how expense ratio will impact your investment if no returns are considered but generally, Mutual Funds gives you some return.
The expense ratio is deducted daily from your invested amount so if you have earned 10% returns then the expense ratio will be deducted on Rs 55000 So you must be thinking Rs 2.7 is very less for you but if you see it from long term perspective it impacts your investments significantly.
Now let’s see with an example, how this expense ratio can impact your investment in the long term of 10-15 years As we have discussed, you have investedRs. 50,000 in a mutual fund.
Let’s consider that you have put themfor 30 years & CAGR is 15% CAGR means compounded annual growth rate. Your return is increasing every yearby 15%.
If you are paying zero expense ratio, with around 15% CAGR,your amount will be around 33 lakh. But if the expense ratio is 2% in 30 years,the amount will be Rs. 18 lakh.
It means that in 30 years, slowly, you have paid Rs. 15 lakh. But if the expense ratio is 0.2%, the amount will be 31 lakh. It means you have paid fees ofonly Rs. 2 lakh in the whole 30 years.
It is normal in mutual funds to charge fees. Whenever you are investing in a fund you should checkwhat is their expense ratio. But it is not right to take decisionsonly on the basis of expense ratio.
But it will give you an ideahow much fees you will be paying. You have to see their past performancethat what was their fees before now what is the fees. And, the expense ratio of the mutual fundcan change.
But whenever they change, Mutual Funds will inform you beforehand that the expense ratio of this fundis increasing or decreasing. There are two types of mutual funds, Regular and Direct. In Direct Mutual Funds,expense ratio is less because you buy these mutual funds directly from AMC.
But if you are buying regular Mutual Fund, distributor charges also add up.Like if you’re buying through a broker, or some advisor or distributor then it is a regular Mutual Fund because it also has their charges.
You might have heard, active mutual fund and passive mutual fund. In active Mutual Fund, fund managers regularly change stocks, they do extra research on them.
Hence, expense ratio of such funds is more. Whereas, you might have seen that in a passive mutual fund they have a set procedure. They have a set criteria.
Hence they do not need to do much research. Therefore they have less expense ratio. I hope, now you have all the information about expense ratio.
If you still have a doubt about anything, comment and let us know If you want knowledge or information about any financial term or investing term, please tell us that through the comment. If you like this article, do share it with your friends and family.