The expense ratio in mutual funds is an “annual fee” charged for managing the scheme. It is deducted from the fund's Net Asset Value (NAV) on a daily basis.
When investing in mutual funds, most investors compare historical returns, fund managers, or portfolio holdings. However, one factor that usually goes unnoticed is the "expense ratio".
It is a yearly fee charged by the fund house for managing and operating the scheme. This cost is deducted from the fund's NAV every day and continues for as long as you remain invested.
The deducted portion no longer remains invested in the scheme and cannot generate returns in the future. Consequently, this reduces the amount available for compounding. As per general industry understanding:
- A higher expense ratio means a larger portion of your investment goes towards fund expenses, while
- A lower expense ratio may allow you to retain more of your returns.
Want to understand in detail? Read this article to first learn about the expense ratio meaning, why AMCs charge it, and how they calculate and deduct it from a scheme's NAV. Lastly, you will also know how the expense ratio affects returns.
Table of Content
What Do You Mean by Expense Ratio in Mutual Funds?
The expense ratio is an “annual percentage fee” that a mutual fund or ETF charges from its investors. This fee is charged to cover the costs of managing the fund, which primarily includes the following components:
| Components | Explanation |
| Fund Management Fees | Compensation paid to the fund manager and investment team for:
|
| Administrative Expenses | May include costs related to:
|
| Distribution and Marketing Expenses | Usually, include costs incurred for:
|
| Legal, Compliance, and Audit expenses | Generally, includes costs associated with:
|
Investment decisions potentially become easier when you understand the concepts behind it. Read more educational blogs on fund costs, returns, risk management, SIPs, and other investing topics. |
How is the Expense Ratio in Mutual Funds Calculated?
As per general industry practice, it is calculated by dividing the fund's total annual expenses by its average Assets Under Management (AUM) during the year. Mathematically, the expense ratio in mutual funds can be represented as follows:
Where:
- Total annual expenses include all the components mentioned above, such as fund management fees, administrative expenses, distribution and marketing costs, and legal, audit, and regulatory expenses.
- Average AUM is the average value of all the money invested in the mutual fund during the year.
For more clarity, let’s study an example.
Example
Suppose a mutual fund has an Average AUM of ₹840 crore and its total annual expenses are ₹12 crore. Now, the expense ratio will be:
How Does a Mutual Fund Deduct Expense Ratio?
Realise that the expense ratio is expressed as an annual percentage, but it is not deducted once a year. Instead, it is accrued and deducted from the fund's NAV on a daily basis.
For example,
- Suppose a fund has an expense ratio of 1.50% per annum.
- Now, the AMC does not deduct 1.50% on the last day of the year.
- Instead, it deducts approximately 0.0041% per day
.
This daily deduction is reflected in the NAV. Over the course of a year, these daily deductions add up to the stated annual expense ratio.
How Does Expense Ratio Affect Returns?
The expense ratio is deducted from the fund’s assets every day, which in turn reduces the fund's NAV. Over a long investment period, these deductions can reduce the amount of money that remains invested and earns future returns.
Let’s understand better through an example.
Example
Suppose you had invested ₹10,00,000 in two mutual fund schemes: Fund A and Fund B. Assume that both funds generate the same “gross return” of 12% per year before expenses, and you stayed invested for 10 years. The Fund A charges an expense ratio of 0.50%, while Fund B charges 2%.
Let’s see how much you would have accumulated after 10 years under both the investment options:
| Particulars | Fund A | Fund B |
| Gross Annual Return (A) | 12% | 12% |
| Expense Ratio (B) | 0.50% | 2.00% |
| Approximate Effective Return (A - B) | 11.50% | 10.00% |
| Potential Value after 20 years | ₹29 lakh | ₹25 lakh |
Investors can observe that although the difference in the expense ratio is only 1.50% p.a., the final investment value differs by approximately ₹4 lakh (₹29 lakh - ₹25 lakh) after 10 years.
Conclusion
So, now you know what the expense ratio is, how it is calculated, and how it is deducted from a mutual fund scheme. To recap, the expense ratio in mutual funds is an “annual charge” levied by the AMC to cover the costs of managing + operating the fund.
It is expressed as an annual percentage, but recovered through daily deductions from the fund's assets (reflected in the form of lower NAV). Since the deducted amount is no longer invested in the fund, it does not participate in future market gains or earn returns through compounding.
For investors evaluating mutual fund schemes, the expense ratio may not be viewed in isolation. Instead, it may be evaluated alongside the fund's:
- Long-term historical performance
- Investment strategy
- Portfolio quality, and
- Personal risk appetite
For more information, you can visit www.tatamutualfund.com/deshkarenivesh. The Investor Service Centre of Tata Asset Management Pvt. Ltd. is located at Mulla House, Ground Floor, 51, M.G. Road, Near Flora Fountain, Mumbai – 400 001, Maharashtra. The office hours are Monday to Friday, 9:00 AM to 5:30 PM. For assistance, you can also call (022) 6282 7777 from Monday to Saturday, 9:00 AM to 5:30 PM, or email service@tataamc.com
Expense Ratio in Mutual Funds FAQs
1. Why do actively managed mutual funds usually have higher expense ratios?
Actively managed funds require fund managers and research teams to:
- Analyse markets
- Select securities, and
- Continuously monitor the portfolio
These activities increase the cost of running the scheme. In contrast, index funds and ETFs only track a market index, so they generally have lower operating costs and lower expense ratios.
2. If the expense ratio in mutual funds is an annual fee, why is it deducted every day?
The expense ratio is expressed as an annual percentage of the fund's assets. However, the AMC does not deduct the entire amount at once.
Instead, a small portion is deducted from the fund's assets every day, and this deduction is reflected in the scheme's daily Net Asset Value (NAV).
3. Do I have to pay the expense ratio separately?
No, the expense ratio in mutual funds is not charged separately or billed to investors. It is automatically recovered by the AMC through daily deductions from the fund's assets. As a result, the returns you see in the NAV are already adjusted for the expense ratio.
Disclaimer
- An Investor Education and Awareness Initiative by Tata Mutual Fund.
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- Please deal only with registered Mutual Funds, details of which can be verified on the SEBI website under ‘Intermediaries / Market infrastructure institutions.
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- Nomination is advisable for all folios opened by an individual especially with sole holding as its facilitates an easy transmission process.
- This communication is a part of investor education and awareness initiative of Tata Mutual Fund.
*Mutual Fund Investments are subject to market risks, please read all scheme related documents carefully.
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