Mutual Fund Expense Ratio

Updated on March 14, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is the Mutual Fund Expense Ratio?

Mutual Fund Expense Ratio is the cost the fund charges relative to the average value of assets during a relevant period and is measured in percentage. The charges include management expenses, advisory fees, travel costs, and consultancy charges; however, brokerage costs for trading are excluded.

Key Takeaways

  • The mutual fund expense ratio represents the percentage of costs charged by the fund in relation to the average asset value during a specified duration. 
  • It encompasses an array of expenses, including management fees, advisory charges, travel costs, and consultancy fees. However, it notably excludes brokerage expenses associated with trading activities.
  • The strategic divestment of underperforming shares is pivotal for trading triumph. Notably, individual investors encounter trading costs in this endeavor. In contrast, investors in mutual funds circumvent such costs, given the pooled nature of fund investments.

Explanation

A Mutual Fund expense ratio is a ratio maintained for the expenses used to run the mutual fund. Costs are the biggest problem in Mutual Funds. These costs, when high, can erode the returns of an investor. Also, high costs happen to be the reason for the below-par performance of some mutual funds.

Two components make these costs: first, the initial expense attributed to establishing a Scheme under a fund, and second, the ongoing recurring expenses. Ongoing recurring expenses are represented by the Expense ratio, also known as Management Expense Ratio. This ratio includes the cost of employing technically skilled investment analysts, administrative costs, and advertisement-related costs for the promotion and maintenance of Scheme funds.

Mutual-Fund-Expense-Ratio

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Source: Mutual Fund Expense Ratio (wallstreetmojo.com)

How to Calculate?

The Mutual Fund expense ratio is calculated by dividing the total expense by the average value of the portfolio. Sometimes as per the company demand, it can be calculated or expressed per unit, and therefore, in that case, the Net Asset Value at the beginning of the year and Net Asset Value at the end of the year is first calculated. Then the average Net Asset Value at the beginning of the year and Net Asset Value at the end of the year is divided by the expenses per unit.

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Examples

A Mutual Fund’s Opening Net Asset Value (NAV) is $20, and the closing Net Asset Value (NAV) is $24. The fund’s annual purchase is $2500, and its annual sale is $4200. The expense per unit is $0.5.

Here the Expense Ratio is calculated by finding out the average of the Opening Net Asset Value (NAV) and closing Net Asset Value (NAV).

Solution:

The average of the Opening Net Asset Value (NAV) and Closing Net Asset Value (NAV) is (20+24)/2, i.e., 22.

Mutual Fund Expense Ratio Example 1
Expense Ratio= Expense incurred per unit/Average NAV.
Mutual Fund Expense Ratio Example 1-1
  • =$0.5/$22
  • = 2.27%.

Therefore the ratio is 2.27%, which means the investor will get the return after deducting this percentage from his actual return.

How to Interpret This Ratio?

The Mutual Fund expense ratio indicates the fund’s return-related capabilities to the investors. Whenever an investment is made through Mutual Funds at that time, the returns that investors earn are usually the returns minus the expense ratio; therefore, it plays a vital role. It is always considered better if this ratio is lower. The investors should understand that the higher the ratio, the lower the expected returns. It plays an important role in making decisions as well.

Importance

The Mutual Fund’s expense ratio plays a vital role for the investors who want to invest in the Mutual Funds. The assessment of this ratio can predict the number of returns the investors can get. It is an indication of the expenses which the Mutual Fund is going to incur to safeguard its stocks and also for the consultancy. The lesser the ratio, the better the investment to be made in that Mutual Fund.

Benefits

  • It helps to indicate to the investors their expected returns.
  • It is a ratio that helps calculate the expense, which is to be incurred by the investors, and that can also be monitored.
  • The experts are hired to make all the calculations of the Expense Ratio. Therefore, it is a very reliable and good decision tool.
  • Costs are the biggest problem of Mutual Funds. If these costs are high, it can discourage the investors; therefore, checking the Expense ratio before investing is always advisable.

Limitations

  • Investors should rely not only on the Mutual Fund Expense Ratio but also on other factors that can decide and affect their returns from the portfolio.
  • The fund houses should make a good attempt to reduce their expense ratio because it is also advisable from the investor’s point of view that the Expense ratio should be the least.
  • The experts who are hired to calculate the Mutual Fund expense ratio are usually very high, and to be on the safer side, this becomes a need for the fund houses to hire the experts to do the job, thus affecting the return from the Mutual Fund.
  • In some fund houses, the expense is not managed thoroughly. Then the advertisement and publicity costs are so higher in those houses that the investors become the ultimate sufferers.
  • The management should take the unmanaged costs because the investors are required to pay the expense ratio amount from their returns.

Conclusion

This is also a true statement for the investment being made in mutual funds. There is no free lunch anywhere. In case of any illness, we visit doctors, who charge us fees. Similarly, the mutual fund houses help us maintain our investments, and they will charge a certain fee and that fee. The Mutual fund expense ratio is exactly how much an investor is required to pay yearly to maintain their investment in the fund houses. The fund houses should keep the expense ratio less to encourage the investors to invest in Mutual funds.

Frequently Asked Questions (FAQs)

1. What are the applications of mutual fund expense ratio?

The mutual fund expense ratio helps investors compare the costs of different funds. It guides investment decisions by evaluating the impact of fees on potential returns. Investors use it to assess the overall cost of owning a fund and understand how expenses might affect their investment outcomes.

2. What is a good mutual fund expense ratio?

A good mutual fund expense ratio is generally lower, as it indicates lower costs for investors. While what’s considered “good” can vary, actively managed funds might have expense ratios around 0.5% to 1.5%, while index funds often have even lower ratios.

3. What are the assumptions of the mutual fund expense ratio?

The mutual fund expense ratio assumes that the fund’s expenses remain relatively stable over time and that the fund’s assets under management (AUM) remain consistent. Historical expense ratios are indicative of future costs. It also assumes that investors are aware of the fees and consider them in their investment decisions.

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