Understanding Mutual Fund Expense Ratio

Mutual funds serve as collective investment pools that professionally manage funds for investors in exchange for a fee, known as the expense ratio. This ratio, measured as a percentage of Assets Under Management (AUM), represents the annual cost of maintaining and operating the fund.

In general, a lower expense ratio is more favorable for investors when other factors remain constant. This is because a reduced expense ratio signifies lower costs for investors, potentially resulting in increased returns on their investments.

Calculation of mutual fund expense ratio

Imagine you've invested Rs. 10 lakhs in a mutual fund with a 2% expense ratio. This translates to an annual fee of Rs. 20,000, calculated as 2% of your initial investment. However, the expense ratio is deducted on a daily basis, not from your invested amount, but from the daily value of your portfolio. This method ensures that you're charged based on the exact number of days you remain invested in the fund and that the fees are calculated in proportion to the daily fluctuations in your portfolio's value.

Components of mutual fund expense ratio

The Total Expense Ratio (TER) encompasses various types of fees charged by mutual funds:

Fund management fees: These fees are allocated to the fund management team, comprising portfolio managers and research analysts. Active funds generally have higher fund management expenses compared to passive funds due to the active management involved in selecting and managing investments.
Administrative expenses: These expenses cover the operational and administrative costs incurred by mutual funds and are factored into the Total Expense Ratio.
Marketing/Distribution fee: This fee constitutes the payments made by mutual funds to advisors or distributors for the distribution of their mutual funds. There are two primary types of mutual fund schemes – Direct and Regular. Direct mutual funds do not charge distribution fees as they are directly sold to investors without an inte