Expenses ratio

Expense ratio (expense to sales ratio) is computed to show the relationship between an individual expense or group of expenses and sales. It is computed by dividing a particular expense or group of expenses by net sales.  Expense ratio is expressed in percentage.

Formula:

Expenses Ratio ( Particular expenses / Net Sales ) * 100

The numerator may be an individual expense or a group of expenses such as administrative expenses, sales expenses or cost of goods sold.

Significance and Interpretation:

Expense ratio shows what percentage of sales is an individual expense or a group of expenses. A lower ratio means more profitability and a higher ratio means less profitability.

Analyst must be careful while interpreting expense to sales ratio. Some expenses vary with the change in sales (i.e variable expenses). The ratio for such expenses normally does not change significantly as the sales volume increases or decreases. For fixed expenses (rent of building, fixed salaries etc.), the ratio changes significantly as the sales volume changes. The ratio is helpful in controlling and estimating future expenses.

In Mutual fund Industry

Annual Fund Operating Expenses, mostly known as the expense ratio, is the percentage of assets payable to the fund manager (i.e. AMC).

The asset manager, with the help of a team of analysts and other experts, allocate, manage (including the auditor and advisor fees) and advertise the fund to maximise returns and manage risks.

If the funds’ assets are small, then the expense ratio can be high. This is because the fund has to meet its expenses from a restricted or a smaller asset base.

Similarly, if the net assets of the fund are significant, then the expense percentage should ideally come down.
On 18 September 2018, SEBI brought about significant modifications by reducing TER of the mutual funds and changing the method of providing a commission to the distributors. Read more about it here

What are the Components of Expense Ratio?

The expense ratio includes numerous charges for smoothly running the mutual fund scheme. They recover this cost from the mutual fund investors on a day-to-day basis.
However, they disclose it to the investors once in every six months. Also, this will have a substantial impact on your take-home returns.
There are three major types of expenses as part of the expense ratio.

There are three major types of expenses as a part of the Expense Ratio. 

a. Management Fees

Mutual funds require the formulation of investment strategies before actually investing money in the underlying assets. Fund managers need to possess a high level of educational, relevant fund management experience, and professional credentials.

The management fee or investment advisory fee is compensation for these managers’ expertise. On average, this annual fee is about 0.50% to 1% of the funds’ assets.

b. Administrative Costs

The administrative costs are the expenses of running the fund. This would include keeping records, customer support, and service, information emails, and communications. They can vary greatly and are expressed as a percentage of fund assets.

c. 12-1b Distribution Fees

Many mutual funds collect the 12-1b distribution fee for advertising and promotional purposes. Usually, they charge their shareholders to market and promote the fund to the investors. These three fees combined are equal to the percentage of assets deducted from the fund.

Expense Ratio Limit By SEBI

All expenses of an AMC must be managed within limits specified under Regulation 52 of SEBI Mutual Fund Regulations. As per these regulations, the total expense ratio (TER) allowed is 2.5% for the first Rs.100 crore of average weekly total net assets, 2.25% for the next Rs.300 crore, 2% for the next Rs.300 crore and 1.75% for the rest of the AUM.
The limit for debt fund is 2.25%. On top of this, the Securities and Exchange Board of India allows all the mutual funds to charge 30 basis points more as an incentive to penetrate in smaller towns (B15 Cities). These cities also enjoy an additional 20 basis points as exit load charges.

How does Expense Ratio impact Fund Returns?

Expense ratios indicate how much the fund charges in terms of percentage annually to manage your investment portfolio. If you invest Rs.20,000 in a fund which has an expense ratio of 2%, then it means that you need to pay Rs.400 to the fund house to manage your money.

In simple words, if a fund earns returns equal to 15% and has TER of 2%, then you will make a return equal to 13%. The Net Asset Value (NAV) of a fund is reported after deducting all fees and expenses. Hence, it becomes essential to know how much are you paying to the fund house.

Expense Ratio Implications

Expense ratio indicates the percentage of sales to the total of individual expense or a group of costs. A lower rate means more profitability and a higher rate means lesser profitability. It becomes critical for schemes with comparatively more moderate yields.

Apart from that, you may use expense ratio to differentiate between actively managed and passively managed funds. In case of actively managed equity funds, the alpha generated by the fund manager is a compelling justification for the fee they charge. If you find a wide divergence between the returns of your fund and index funds, then you may think of making a switch.