Like a doctor who charges you for his service, mutual funds too charge a fee for managing your money. This involves the fund management fee, agent commissions, registrar fees, and selling and promoting expenses.
Expense ratio states how much you pay a fund in percentage term every year to manage your money. For example, if you invest Rs 10,000 in a fund with an expense ratio of 1.5 per cent, then you are paying the fund Rs 150 to manage your money. In other words, if a fund earns 10 per cent and has a 1.5 per cent expense ratio, it would mean an 8.5 per cent return for an investor.
Since this is charged regularly (every year), a high expense ratio over the long-term may eat into your returns massively through power of compounding. For example, Rs 1 lakh over 10 years at the rate of 15 per cent will grow to Rs 4.05 lakh. But if we consider an expense ratio of 1.5 per cent, your actual total returns would be Rs 3.55 lakh, nearly 14 per cent less than what would have been achieved without any expense charge.
Different funds have different expense ratios. The largest component of the expense ratio is management and advisory fees. From management fee an AMC generates profits. Then there are marketing and distribution expenses. All those involved in the operations of a fund like the custodian and auditors also get a share of the pie. Interestingly, brokerage paid by a fund on the purchase and sale of securities is not reflected in the expense ratio. Funds state their buying and selling price after taking the transaction cost into account.
In case of actively managed equity funds, the issue of expenses is more complicated. The wide divergence of returns between 'good' and 'bad' funds makes the expense ratio secondary. But here too, if you find two similar mutual funds, the expense ratio can be a good differentiator. Perhaps, more important is the fact that expenses are charged at all times. Whether a fund generates positive or negative returns, expenses are always there.
Recently, funds have launched institutional plans for big-ticket investors, where the expense ratio is relatively lower than normal funds. This is because the cost of servicing is low due to larger investment amount, which means lower expenses. Overall, before venturing into any fund just check out this important number. A lower expense ratio does not necessarily mean that it is a better-managed fund. A good fund is one that delivers good return with minimal expenses.