You may have come across the term ‘expense ratio’ when you go through the fact sheet of a mutual fund. Expense ratio is the cost incurred to operate the fund. It is a portion of your invested money that goes into managing your fund. The expenses include costs pertaining to fund management cost, registrar fees, agent commission, promotional expenses, etc.
There are different expense ratios for different funds. Mutual Fund Regulator SEBI has put a limit on the expenses charged based on the type of fund. A fund can charge a maximum of 2.5 percent of the average weekly net assets. The NAV of the fund is calculated after deducting this charge. SEBI has made the expense ratio slabs for mutual funds such that higher the AUM (assets under management) size of a scheme, lower the expense ratio; and vice versa.
Expense ratio does not matter much for an equity fund
Expense ratio for an equity fund is on an average between 2 and 2.5 percent. When it comes to actively managed equity funds, the expense ratio assumes secondary importance. Since equity mutual funds deliver substantially high returns on a long-term basis, the expense ratio does not make a big difference.
When it comes to choosing a top performing equity mutual fund, look out for good, consistent performance rather than expense ratio. However, if you are faced with two funds that have similar strategy, performance and track record, you can go for the one with a lesser expense ratio.
Expense ratio matters a lot more for a debt fund
Expense ratio plays a decisive role in debt funds, because they do not generate returns as high as equity funds. For example, gilt funds were on a roll giving returns to the tune of 14 percent before going down to single-digit returns last year. When you are looking at long-term returns falling in 7 to 8 percent bracket on such funds, expense ratios do make a big difference. In that case, a fund with 1. 4 percent expense ratio will definitely give better returns that the one with 2.2 percent.
As per research, most of the Debt Mutual Fund Managers of categories like Monthly Income Plan(MIP), Income Funds, Gilt Funds, Dynamic Bond Funds etc. who charge high Expense Ratio are not able to generate enough Alpha or extra return by active management to compensate for the higher expense ratio charged by the fund.