Mutual Fund Expense Ratio

What is Mutual Fund Expense Ratio?

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

Explanation

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 into the returns of an investor. Also, high costs happen to be the reason for the below-par performance of some mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more.

There are two components that make these costs, first is the initial expense attributed to establishing a Scheme under a fund, and secondly, it is 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 costsAdministrative CostsAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more, advertisement related costs for promotion and maintenance of Scheme funds.

Mutual-Fund-Expense-Ratio

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For eg:
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 companies demand, it can be calculated or expressed in terms of per unit and therefore, in that case, the Net Asset ValueNet Asset ValueNet Asset Value is calculated by subtracting the total value of the entity's liabilities from the total value of its assets and dividing the result by the total number of outstanding shares.read more for the beginning of the year and Net Asset Value at the end of the year is first calculated and then the average of the Net Asset Value for the beginning of the year and Net Asset Value at the end of the year is divided with the expenses per unit.

Examples

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

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 is an indication to the investors about the Mutual Funds return related capabilities. Whenever an investment is made through Mutual Funds at that time, the returns which investors earn are usually the returns minus the expense ratio; therefore, it plays a very vital role in that. It is always considered better if this ratio is lower. The investors should understand that the higher the ratio, the lower returns they should expect. Actually, it plays an important role in making decisions as well.

Importance

An expense ratio of the Mutual Fund plays a very vital role for the investors who want to invest in the Mutual Funds. The assessment of this ratio can predict the number of returns that the investors can get. It is an indication of the expensesExpensesAn expense is a cost incurred in completing any transaction by an organization, leading to either revenue generation creation of the asset, change in liability, or raising capital.read more which the Mutual Fund is going to incur to safeguard their stocks and also for the consultancy. The lesser the ratio, the better would be the investment to be made in that Mutual Fund.

Benefits

  • It helps to indicate the investors about their expected returns.
  • It is a ratio that is helpful for the calculation of 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 much reliable and good decision tool.
  • Costs are the biggest problem of Mutual Funds. If these costs are high, then it can discourage the investors; therefore, it is always advisable to check the Expense ratio before investing.

Limitations

  • The investors should not only rely upon the Mutual Fund Expense Ratio, but there are other factors also which 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 least.
  • The experts who are hired to calculate the Mutual Fund expense ratio are usually very high, and to be on a safer side, this becomes a need for the fund houses to hire the experts to do the job, and thus this also affects the return from the Mutual Fund.
  • In some fund house, the expense is not managed thoroughly, and then the advertisement cost and the publicity cost is so higher in those houses that the investors become the ultimate sufferers.
  • The unmanaged costs should be taken care of by the management because the investors are required to pay the expense ratio amount from their returns.

Conclusion

There is no free lunch anywhere. This is also a true statement for the investment being made in mutual funds. Like in case of any illness, we visit doctors, and doctors charged us the 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 every year to maintain their investment in the fund houses. The fund houses should keep the expense ratio less so that they can encourage the investors to invest in Mutual funds.

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