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The role of expense ratio in mutual fund investing

While investing in mutual funds, many investors are quick to focus only on the potential returns of the fund. It is easy to see why, after all, investing is all about building wealth over time and achieving different financial goals. But, there is another important factor to look at: Total Expense Ratio (TER).

It is a measure that indicates how much you have to pay toward fees each year when you invest in a mutual fund. This fee is deducted from a fund’s assets and can have a significant impact on your net returns. This fee can range from a few tenths of a percent to over two percent, depending on the scheme and its objectives.

While it seems like a small percentage, the expense ratio can have a major impact on an investor’s net profitability. On that note, let’s highlight the importance of expense ratios in mutual fund investing, how they can impact your returns, and what you should know before selecting a mutual fund with a specific expense ratio.

How much is the mutual fund expense ratio?

While the expense ratio can vary across different mutual funds, the Securities and Exchange Board of India (SEBI) has imposed a cap on the maximum permissible limit that funds can charge. For equity mutual funds, the maximum TER limit is 2.25%, while for debt fund investments, it is 2%.

Impact of expense ratio mutual fund returns

Expense ratio has a direct impact on your mutual fund investment returns. The higher the expense ratio, the more of the fund’s assets are used to pay these fees, reducing the returns that investors can earn.

Consider investing in two mutual funds that generate an annual return of 10%, but have different expense ratios. If one mutual fund scheme has an expense ratio of 2%, your investment return will be reduced by this amount, leaving you with a net return of 8%. If you buy a mutual fund with a low TER of 0.5%, your total returns will increase to 9.5%. This simple example shows how expense ratios are important in determining your returns.

Components of mutual fund expense ratio

  • Management fees

Different types of mutual funds incur different management fees, which can range between 0.50% to 1% (or more) of the fund’s assets. The management fee covers the cost of research, analysis, and investment decisions the fund’s investment team makes. Generally, actively managed funds have higher management fees than passively managed funds.

  • Administrative or operating expenses

These expenses cover the cost of running the fund, such as customer support and service, keeping records, and information emails.

  • 12B-1 fee

12B-1 fees cover marketing and distribution fees, helping mutual funds distribute their shares and increase their assets under management.

Should you always go for a fund that has the lowest expense ratio?

Choosing a mutual fund scheme only on the basis of a lower expense ratio is not always the smartest decision. The fund’s performance and its consistency of returns are equally important considerations.

For example, a low-cost index mutual fund may have a lower expense ratio than actively managed funds but may not necessarily deliver the best returns. While an actively managed fund with a higher expense ratio may be able to beat other investments consistently and generate higher returns for investors.

To wrap up

With any investment, it is important to understand the amount of money being charged to manage your investment. So, regularly check the expense ratio of any fund you plan to invest in and compare it with other investment options. Check out the fund house or AMC website for updated details on expense ratios, and make informed decisions that align with your financial goals.

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