What is an Expense Ratio in Mutual Funds?

What are Good Expense Ratios for Mutual Funds?

A good expense ratio for a mutual fund depends on your investment goals, risk tolerance, and other factors. Generally, a low expense ratio is good as it means that more of your money is being invested rather than being used to cover operating costs.

*For reference only

How Expense Ratio Affects Mutual Fund Returns?

As an investor, the expense ratio directly affects your returns from a mutual fund. Since this fee is deducted before distributing profits, a higher expense ratio means a larger portion of your potential returns is used for operational costs. This, in turn, leaves you with a lower net return.

Given its impact on your earnings, it’s essential to analyse and compare expense ratios before selecting a mutual fund.

Myth: Higher Expense Ratio Means Better Management

A common misconception is that a higher expense ratio indicates better management and a higher chance of profitability. However, mutual funds with low expense ratios can still generate strong returns when managed efficiently by skilled fund managers.

High vs Low Expense Ratios

• Low Expense Ratios (0.5% – 0.75%): Managed efficiently, these funds can maximise your returns without excessive fees
• High Expense Ratios (Above 1%): Can significantly eat into your profits, so it’s important to evaluate whether the fund’s performance justifies the cost
• Very High Expense Ratios (Above 1.5%): These funds may have excessive fees, requiring careful scrutiny before investing

Formula to Calculate Expense Ratio

While most mutual funds disclose their expense ratio in their prospectus or on their website, you can calculate it using the following formula —

Expense Ratio(%) = (Total Expenses/Average AUM) × 100

Mutual Fund Expense Ratio Calculation

Let’s say if a mutual fund has total expenses of AED 12 and an average AUM of AED 600, the expense ratio would be —

(12/600) × 100 = 2%

In this case, each investor contributes 2% annually as the expense ratio. This deduction is made throughout the scheme's investment duration.

Key Components of the Expense Ratio

• Total Expenses – Covers all costs incurred by the fund, including fund manager salaries, marketing, distribution, legal, and audit fees
• Average AUM (Assets Under Management) – Represents the total value of pooled investments in the fund

Another Example

If a mutual fund has an expense ratio of 1% and a total AUM of AED 20,000, the mutual fund company will charge —

(1/100) × 20,000= AED 200

This fee is deducted from the fund's Net Asset Value (NAV) before it is announced daily.

Components of Expense Ratio

Here are the major components of expense ratio in mutual funds —

How to Find Funds with Low Expense Ratios?

Finding low-expense ratio mutual funds can be crucial for boosting long-term returns. Here’s how you can identify them —

• Opt for Passively Managed Funds: Index funds and ETFs typically have lower expense ratios than actively managed funds. This is because the former tracks a market index instead of relying on extensive research and frequent trades.
• Consider Index Mutual Funds: These funds mimic the performance of indices like Nifty 50 or S&P 500 and have lower management costs.
• Look for Exchange-Traded Funds (ETFs): ETFs are passively managed, making them a cost-effective investment choice with low expense ratios.
• Compare Expense Ratios Online: Some platforms help you compare and select funds with the lowest expense ratios in your preferred category.
• Choose Direct Plans Over Regular Plans: Direct plans eliminate distributor commissions, leading to lower expense ratios compared to regular plans.

Frequently Asked Questions