A mutual fund allows you to invest in a basket of securities be they equities, debt or even commodities in one go. The setup here is simple. You invest in the fund (either through SIP investment or a lumpsum) on top of which you pay a managerial fee to the fund managers who look after the fund on your behalf and invest according to market conditions and their investment thesis. If the fund does well, you do well. Simple as that. However, before you rush to open a demat account to invest in mutual funds, there is a key indicator that you should look out for. This is the Expense Ratio of the mutual fund.. Let’s take a look at what this is, and how it affects you as an investor and your returns.
Expense ratios
The expense ratio of a fund, oftentimes also referred to as the management expense ratio, is the percentage of the funds assets that are being used to meet administrative expenses. What might these be , you ask?
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Administrative Costs: These account for the costs of running an investment fund such as the cost of providing service, the cost of equipment, information emails and record keeping activities.
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Distribution Fees: A number of mutual funds collect 12-1b distribution fees which are used for advertising and promotions. This is effectively the marketing budget of the fund, if one is looking for a simplistic explanation.
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Management Fees: As mentioned earlier, this is the fee you pay the fund managers in the fund for their level of knowledge and education that they employ in order to make relevant investment decisions etc. Generally, this amounts to about 0.5% to 1% of the mutual fund you are looking to make lump sum or an SIP investment in
How Do Expense Ratios Affect the Investor?
One can carry out a simple calculation in order to understand how the expense ratios of a fund will affect you and your SIP or lump sum investments as an investor.
Let’s assume you chose to invest 50,000 in a mutual fund, and that fund has an expense ratio of about 2%. In this case, you will effectively be paying about 1,000 rupees to the fund as a fee to manage your money, and so the amount you’ve invested in the fund is actually Rs 49,000.
Other than simply making you pay a flat fee, expense ratios can also provide an indiciation of the profitability of the fund (i.e, how much are they being able to make for what they put in) The formula for expense ratio is the Funds total Expense / Total Assets. Thus, you could assume that a fund with a low expense ratio, has a high asset value, for comparatively little costs in terms of administration, managerial and marketing costs. This isn’t wrong, but you should be aware that is not the full picture. What you should really be looking for is whether or not a fund is beating the average returns of the index, and the competition. If you have a higher expense fund with great returns, that would be a better bet for you.
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