What is Expense Ratio?

The expense Ratio is the ratio of expenses to premiums generated. Using it, companies can determine their efficiency.

When it comes to investing in mutual funds or exchange-traded funds (ETFs), one of the most important factors to consider and understand is the expense ratio. An expense ratio measures how much you’ll pay over the course of a year to own a fund. A high expense ratio can significantly impact your returns. It pays for things like the management of the fund, marketing, advertising & any other costs associated with running the fund. Both mutual funds and ETFs charge an expense ratio.

When someone discusses how expensive a fund is, they’re referring to the expense ratio. Here’s how expense ratios work and what makes a good expense ratio.

What is Expense Ratio?

After the loss ratio, Expense Ratio is the second critical ratio which is the percentage of expenses (other than paid claims) to the premium generated during the period. It assists companies in analysing the company’s efficiency; the lower the ER, the better the profitability. 

It is how much you pay a mutual fund or ETF per year, expressed as a percent of your investments. So, if you have $5,000 invested in an ETF. And have an expense ratio of .04%, you’ll pay the fund $2 annually.

An expense ratio is determined by dividing a fund’s operating expenses by its net assets. Operating expenses reduce the fund’s assets, thereby reducing the return to investors because the expense ratio is deducted from the fund’s gross return and paid to the fund manager.

It’s very rare to need to calculate a fund’s expense ratio, as it is required to state it in its prospectus. Additionally, because it is an important metric for investors, expense ratios are almost always found on a fund’s website. But if you need to calculate it, this is the formula:

ER = Total Fund Costs/ Total Fund Assets

​ER= Total Fund Assets/ Total Fund Costs

​Where:

Total Fund Costs: The total of all management, transfer agent, accounting, custodian, trustee, auditing, legal, interest, miscellaneous, and other relevant operating fees (does not include loads or commissions)

Total Fund Assets: The fund’s net assets

You will need to locate the fund’s operating expenses in its financial statements and net assets on its webpage (or financial statements).

Components of an Expense Ratio

Most expenses within a fund are variable; however, the variable expenses are fixed within the fund because of how it is calculated. For example, a fee consuming 0.5% of the fund’s assets will always consume 0.5% regardless of how it varies.

In addition to the management fees associated with a fund, some funds have an advertising and promotion expense referred to as a 12b-1 fee, which is included in operating expenses. Notably, 12b-1 fees within a fund cannot exceed 1% (0.75% allocated to distribution and 0.25% allocated to shareholder servicing) according to FINRA rules.

A fund’s trading activity—the buying and selling of portfolio securities—is not included in the calculation of the expense ratio. Costs not included in operating expenses are loads, contingent deferred sales charges (CDSC), and redemption fees, which, if applicable, are paid directly by fund investors.

What are the Components Of Expense Ratio?

Workings of a mutual fund are complex, with numerous factors playing a significant role in behind its successful performance. Complete information about these costs and its breakups are released to the investors, to ensure transparency. These charges are revealed via a statement every 6 months, depicting the amount deducted from the account of the investors to meet these costs.

Management Fees

Various types of charges present in a mutual fund expense ratio are –

This charge is allocated towards the payment of the people responsible for the operation of a mutual fund. Portfolio and fund managers devote considerable time and energy to determine profitable investment opportunities through rigorous market research and calculated predictions.

Generally, 0.5-1% of the total asset base is deducted as management fees of a mutual fund.

Administrative Costs

Total cost incurred to ensure smooth operations and other administrative duties are added to this tab. Maintaining proper records of the investors, entry and exit fees of the portfolio assets, customer support, etc. can be categorized under the maintenance costs of a mutual fund.

Marketing and Distribution Costs

This represents the amount spent on the promotion of the relevant mutual fund. Creating an adequate asset base requires information which has to be spread among the masses regarding the same. The charge of a new individual investing in the mutual fund is also calculated under the 12-b FEE, and thereby, a component of the total expense ratio of the fund.

It is the amount that has to be paid by an investor while joining a mutual fund. This reduces the total disposable income over which a person earns interest. Different mutual funds charge different percentages on entry, at the discretion of the concerned asset management company. However, as per recent SEBI regulations, the entry load is abolished from the calculations of the total expense ratio of a mutual fund.

Similarly, exit load is the amount payable when a person chooses to withdraw from a mutual fund. This charge is payable on the total investment of an individual, usually standing at 2-3%. This is used as a tool to discourage people from withdrawing funds from a mutual fund.

Brokerage Fees

Mutual funds can be of two plans – direct or regular. In case of regular plans, an asset management company (AMC) hires a broker. It is for all the transactions to be processed concerning the purchase and sale of the shares of the portfolio asset. Direct mutual funds, on the other hand, process these transactions by themselves.

Brokerage fees add on to the expense ratio of a regular mutual fund, while direct funds do not have this burden. Mutual fund expense ratio list of every such fund is readily available on the official website. It allows potential investors to have complete knowledge about the product blocking a substantial amount of their finances.

Expense ratios also depend upon the duration and maturity of a mutual fund. The details regarding these can be easily viewed directly from the official website of the mutual fund you wish to purchase.

How Does the Expense Ratio Impact Fund Return?

Expense ratios are usually deducted from total revenue generated by a mutual fund, before disbursing it to the investors. Higher expense ratios imply a higher proportion of the returns being removed, thereby providing lower returns on investments.

Expense ratios levy a burden on annual returns earned. So an investor should carefully analyse the same while choosing a mutual fund scheme to invest.

Why is the ER important?

We generally consider these ratios critical for analysts to analyse the performance of an insurance company. It also assists analysts in comparing different insurance companies operating in the same market. 

What Does Expense Ratio Mean?

The expense ratio is how much of a fund’s assets are used towards administrative and other operating expenses. Because an expense ratio reduces a fund’s assets, it reduces the returns investors receive.

Why Is Expense Ratio Important?

The ETF is important because it lets an investor know how much they pay to invest in a specific fund. It also tells How much their returns will be reduced. The lower the expense ratio the better because an investor receives higher returns on their invested capital.

How Is Expense Ratio Calculated?

The expense ratio is calculated by dividing a fund’s net expenses by its net assets.

The Bottom Line

Expense ratios are taken from mutual fund and ETF returns to help pay for operations and fund management. The expense ratio charged to investors will vary depending on the fund’s investment strategy and level of trading activity. In general, expense ratios have declined steadily as competition for investor dollars has heightened