Expenses Needs to Consider while investing in Mutual Funds

Expense Ratio

The ratio is also known as recurring expenses. This is incurred to run and manage a MF scheme and are charged as a percentage of the net assets of the fund. Expense ratio states how much you pay a fund in percentage term every year to manage your money. Since this is charged regularly (every year), a high expense ratio over the long-term may eat into your returns massively through power of compounding. Different funds have different expense ratios. But the Securities & Exchange Board of India has stipulated a limit that a fund can charge. Equity funds can charge a maximum of 2.5 per cent, whereas a debt fund can charge 2.25 per cent of the average weekly net assets.

As per the Securities and Exchange Board of India (Sebi) MF guidelines the equity funds can charge a maximum of 7 per cent as expenses. The SEBI guidelines emphasizes on the  corpus of the fund goes up, the expenses should drop, on account of economies of scale. Hence, the regulations permit equity funds to charge 2.5 per cent for average daily net assets of up to Rs 100 crore, 2.25 per cent for the next Rs 300 crore and 2 per cent for the next Rs 300 crore. For the rest of the assets, the maximum limit is 1.75 per cent. In case of debt funds, the maximum limit is reduced by 0.25 per cent for each of the above slots as they have a lower risk-return profile than equity funds. The regulator recently mandated, that index funds can charge a maximum of 1.5 per cent as expense ratio, as they are passively-managed. 

The expense ratios of equity and debt funds differ. Since the expenses of equity funds are more than those of debt funds, the expense ratio on equity funds is greater. As per the regulations of the Securities and Exchange Board of India (SEBI), a mutual fund can charge a maximum expense of 2.5 per cent (equity funds), 2.25 per cent (debt funds), 1.5 per cent (index funds) and 0.75 per cent (Fund of Funds).

The expense ratio charged is used to meet the fund’s day-to-day expenses like costs related to dispatching investor communications such as account statements, dividend and redemption cheques, advertisements, trustee fees and expenses, custodian fees, among others. 

The largest component of the expense ratio is management and advisory fees. From management fee an AMC generates profits. Then there are marketing and distribution expenses. All those involved in the operations of a fund like the custodian and auditors also get a share of the pie. Brokerage paid by a fund on the purchase and sale of securities is not reflected in the expense ratio. Funds state their buying and selling price after taking the transaction cost into account. Recently, funds have launched institutional plans for big-ticket investors, where the expense ratio is relatively lower than normal funds. This is because the cost of servicing is low due to larger investment amount, which means lower expenses. A lower expense ratio does not necessarily mean that it is a better-managed fund. A good fund is one that delivers a good return with minimal expenses.

Management fee. 

A crucial part of these expenses is also what the asset management company charges an investor on account of the professional service they render of managing the investor’s funds. It is also called investment management and advisory fee. Though this is included in the total expense ratio, Sebi has prescribed that funds can charge a maximum of 1.25 per cent of an investor’s average daily net assets up to Rs 100 crore and 1 per cent on the balance amount. 

Exit load Just like an investor pays a load when he enters an MF, he is required to pay a load when he exits a fund. Called the exit load, it is levied as a percentage to the applicable net asset value (NAV) at the time of exit. So, if a scheme with an NAV of Rs 50 carries an exit load of 1 per cent, the price at which the investor sells the units of this scheme (called the repurchase price) will be Rs 49.50.

The formula used to calculate repurchase price for a scheme with an exit load is:

Repurchase Price=Applicable NAV x (1-Exit Load) 

Exit loads are charged to deter premature redemptions. For instance, in most schemes, the exit load varies according to the period of investment. This step-wise exit load is also called the contingent deferred sales charge and continues to drop over a period of time. In simple words, the longer an investor stays invested, lesser is his exit load. Besides deterring premature redemptions, exit load is also charged to cover advertising expenses and other costs incurred for managing the scheme. Some MFs use the exit load to pay the distributor. There is, however, no rule to define where the exit load should be spent.

Sebi regulations mandate that the maximum load charged (either entry or exit) cannot exceed 7 per cent. Also the difference between entry and exit loads cannot be more than 7 per cent.