Explained: What is Total Expenses Ratio, its importance and impact?
Investing in mutual funds comes at a cost. There are certain expenses that an investor has to pay while investing in mutual funds. When making any investment decision, it is important to know all the associated costs with investing and one such cost is the total expenses ratio.
What is total expenses ratio?
Beginners in the market might have the question ‘what is expense ratio?’. Expense ratio can be termed as the amount of money that a mutual fund house charges to its clients to finance its operations, administrative costs and for maintenance charges. The ratio is a representation of the expense in relation to the assets of the mutual fund.
Expense ratio is the amount of money that an investor has to pay over a period of a year in order to own the mutual fund scheme. This is a cost that an investor bear which also reduces the investment value by a small amount. Therefore, it is always beneficial for an investor to select a fund with a lower expense ratio.
What are the Components of Expense Ratio?
To be an informed investor, it is helpful to understand the various components of the expense ratio.
For a mutual fund scheme to generate higher returns, it is important to manage it properly and ensure that investment objectives are met. The management fees are charged in order to pay the fund and portfolio managers who make important decisions related to the fund. Usually, around 0.5-1% of the total asset base is allocated as management fees.
Many investors trust mutual funds as a good investment vehicle. In order to uphold this image, a fund needs to comply with the laws, rules and regulations. The fund also needs to be audited in order to make sure that all the schemes and processes of the fund are in check. A part of the expenses ratio is used to meet the costs that arise out of the various legal and auditing procedures.
Costs associated with marketing
As a fund, it is important to raise awareness and get investors to invest money in the fund. Most funds operate on a large scale therefore, the costs associated with marketing and distribution is an important component in the expense ratio. The costs of acquiring a new investor are calculated under 12-b FEE. In order to distribute a regular mutual fund, a broker is required. These costs are calculated in the expense ratio as well.
Apart from these costs, the expense ratio also comprises the maintenance, administrative, brokerage fees, entry and exit loads.
Importance of Expense Ratio
Expense ratio is a critical factor when analyzing or making investing decisions. Here are some reasons that highlight the importance of the expense ratio.
Comparing different funds
Expense ratio is helpful in order to compare different funds. Since the expense ratio affects the returns and has a direct impact, an investor can use the ratio as one of the factors to compare various funds. The higher the expense ratio, the lower the returns. Using the expense ratio to compare funds can be helpful especially if the funds are similar in nature.
Effect on debt funds
The expense ratio is significant when it comes to debt funds. Since debt funds offer low returns, the expense ratio might eat away at some of the profits generated by the fund. Therefore, an investor should carefully look at the expense ratio of a debt fund before investing in one.
Typically, we associate high costs with high quality but that might not always be the case. Similarly, while looking at funds, it is important to consider other factors as well. A fund might not perform well in spite of having a high expense ratio. Certain funds can be well managed and provide significant returns even with a lower expense ratio.
How Does the Expense Ratio Impact Fund Return?
The expense ratio is inversely related to the size of the mutual fund. This means that larger mutual funds usually have a lower expense ratio. The expense ratio is important as it is deducted from the revenue of the funds. Higher expense ratios will often chip away at the returns, affecting the mutual fund and the investors.
As an investor, the expense ratio should be a factor that you consider along with various other aspects of a mutual fund. Knowing the various costs associated with mutual funds and how they will affect your returns is important. While selecting a mutual fund, an investor should also look at the management, risk level and asset allocation.
How do you calculate total expense ratio?
Total expense ratio is calculated by dividing the total costs of the mutual fund by the total assets of the mutual fund.
What is a good total expense ratio?
A total expense ratio between 0.5% and 0.75% is considered to be good in the case of an actively managed fund.
How does expense ratio get paid?
A percentage of the total expense ratio is deducted daily from the invested value. For example, if the expense ratio is 1% then 1/365 = 0.0027% of the invested value is deducted daily.
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