The purpose of writing this article is to highlight how the expense ratio is calculated and deducted by mutual fund schemes from our investments. Many people think that the expense ratio of mutual funds is a one-time expense. But on the contrary, it gets deducted from our investment on a daily basis. The daily deduction will continue as long as the mutual fund units are held. Surprised, right? Please read further and you’ll get more insights. To get quick answers, read the FAQs.
How The Expense Ratio is Charged
Suppose your mutual fund investment portfolio is worth Rs.25 lakhs as of today. The declared expense ratio of the portfolio is 1.78% (say). It means a sum of Rs.121.9 is deducted from your portfolio each day. On an annual basis, an average sum of Rs.44,500 (=Rs.121.9 x 365 days) is deducted from your portfolio. The sum of Rs.44.5K is equivalent to 1.78% of your portfolio size (1.78% = 44,500/25,00,000).
The actual calculation of the expense ratio charged on investments is more complicated than what is shown above. The deduction amount will change every day with the daily fluctuations of the scheme’s NAV. Allow me to show you how.
Suppose an investor holds 38,000 number units of Axis Mid Cap mutual fund. The expense ratio of this scheme is 1.78% per annum. The approximate value of this investment is Rs.25 lakhs.
The above infographics show the daily NAV of Axis Midcap Fund from 15-Jan’23 to 20-Jan’23. Check how the calculated expense ratio changes with the change in the fund’s NAV.
For example, on 20-Jan-2023, the NAV of the scheme was Rs.65.04 per unit. As the investor holds 38,000 units of the scheme, the value of the investment will be Rs.24,71,520 (= 65.04 x 38,000).
The calculated expense ratio on this date will be Rs.120.53 (=1.78% / 365 * 24,71,520). It means that, on this day, a value of Rs.120.53 was deducted from the investor’s portfolio. Similarly, the expense ratios were deducted on the other dates as well. On the six dates shown above, the total expense ratio deducted from the investor’s portfolio was Rs.728.68.
As per SEBI’s guidelines, the said mutual fund scheme can deduct the expense ratio daily from the investor’s portfolio. But there is an upper limit on it. The total amount should not be greater than the declared expense ratio, 1.78% of the average NAV (or value of investment). Suppose, in the year 2023, the average value of the investment was Rs.25 lakhs. Hence, the sum of all daily deductions should be less than Rs.44,500 (=1.78% * Rs.25,00,000).
Please note that the expense ratio will be deducted (charged) daily from the investment till the investor stays invested. The deduction will continue to occur irrespective of whether the NAV is rising or falling. Even if our example investor sees a negative NAV growth in a financial year, he will still be charged Rs.44,500 as his fund’s expense ratio is 1.78% and his portfolio size if Rs.25 lakhs.
Compare: Expense Ratio of Mutual Funds vs Stocks
Yes, even stock investing has a cost. Here, one has to pay charges under the head of the brokerage, transaction costs, GST, Security transaction tax, Stamp duty, and Demat charges.
I’ve considered the charges levied by AxisDirect on stock trades. The extra cost payable on every stock trade is about 0.712%. The percentage is payable when one buys the stocks and also on selling. An annual recurring expense of about Rs.650 is also payable as Demat charges. In a portfolio size of Rs.25 Lakhs, this recurring expense is only 0.03% of the invited amount.
Let’s compare the cost of holding a similar size mutual fund portfolio vs a stock portfolio.
- One-Time Expense: A mutual fund portfolio does not have this cost. A stock portfolio will have this cost of about 0.712% of the portfolio size. For a portfolio size of about Rs.25 Lakhs, this cost comes to Rs.17,800. If one will use other discount brokers, this cost can be further minimized.
- Recurring Expense (Annual): A mutual fund portfolio has this recurring cost. It is equal to the expense ratio of the scheme. For a portfolio size of Rs.25 Lakhs, at a 1.5% expense ratio, the cost comes out as Rs.37,500. The recurring cost attributable to the stock portfolio will be Demat charges which will be about Rs.650 only.
How to interpret this data about the mutual fund’s expense ratio and stock’s cost of trade? Allow me to show it using a hypothetical example. Suppose there are two friends, one holds a stock portfolio and the other a mutual fund portfolio (expense ratio 1.5%). The size of the portfolio for both friends is Rs.25 lakhs. Both of them continue to hold onto their portfolio for 5 years. Let’s compare their costs for holding the corpus.
I am assuming an average growth of the mutual fund’s NAV at 8% per annum. Taking these numbers, the cost of holding comes out as shown below:
In a 5-year period, the cost of holding a mutual fund portfolio of Rs.25 Lakhs size, with an expense ratio of 1.5%, will be about Rs.2.37 lakhs. The cost of holding a similar stock portfolio is only Rs.21,000. The mutual fund portfolio is costing eleven (11) times higher than a stock portfolio.
Though this comparison goes heavily in the favour of stock investing, mutual funds have their own benefits. To get a better perspective of the two, check this article on shares vs mutual fund investing.
Impact of Expense Ratio on The Returns (ROI)
To understand the impact of the expense ratio, we’ll compare the return of the mutual fund’s regular plan versus its direct plan. The expense ratio of a direct plan is lower than its regular plan. Why? Because direct plans are sold directly by the fund house to the investors, there are no distributors in between. Hence, the commission cost on the sale of the direct plan is saved.
|Description||Axis Midcap- Regular||Axis Midcap-Direct|
|Investment||Rs 25,00,000||Rs 25,00,000|
|Holding period||5 Years||5 Years|
|Deductions (Expense Ratio)||Rs 2,22,500||Rs 66,250|
|Maturity Amount||Rs 47,48,444||Rs 50,59,075|
You can see, for the same mutual fund scheme, the annualized return of the direct plan is higher. Though both these schemes have an identical underlying portfolio, still their returns are different. The direct plan is yielding a return of 15.14% vs 13.69% for the regular plan.
Why it is so? The cause of this difference in return is the lower expense ratio of the direct plan. A higher expense ratio of a regular plan reduces its returns. The total expense deducted in a period of five years is Rs.2,22,500 for the regular plan and only Rs.66,250 for the direct plan.
The result of the lower expense ratio of the direct plan is reflected in the market value of the investment at end of the fifth year. The investment parked under a direct plan was worth Rs.50,59,075, which is 6.54% higher than the investment parked under the regular plan (Rs.47,48,444). To know more about the difference between a regular plan vs a direct plan, check this article.
Mutual fund schemes are managed by experts. One such expert is the fund manager whose expense is accounted for under the management fees. There are other expenses as well like administrative expenses, etc. All such expenses, as per SEBI’s guidelines, are clubbed together and passed on to the investors as a percentage of their investments called the Total Expense Ratio (TER). The expense ratio of 1.5% means, out of the total Rs.100 invested by a person, Rs.1.5/365 will be paid DAILY as fees to the fund house till the money stays invested. Read more about mutual fund charges.
The expense ratio is the total cost of managing a mutual fund scheme, the operating expense, expressed as a percentage of the average asset under management (AUM). Expense Ratio = Total Cost / Average AUM.
All Operating Expenses: (1) Sales, Marketing (advertising) expenses, (2) Administrative expenses, (3) Transaction costs, (4) Investment management fees, (5) Registrar fees, (6) Custodian Fees, and (7) Audit fees
Suppose a mutual fund scheme has an expense ratio of 1.5%. During a holding period, the market value of all assets held in the fund’s portfolio grew by 12%. In this case, the mutual fund is allowed to keep 1.5% of the total return, which means the return passed on to the investor is only 10.5% (=12%-1.5%).
Have a happy investing.
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