Expense Ratio of Direct and Regular Mutual Funds

Mutual funds have become an integral part of the investment portfolio of almost every investor in the country due to the multiple benefits offered by them. Investors can potentially double their investment in a few years which is definitely not the case with traditional investment options. 

While there are many costs associated with investment in mutual funds, the most common expense is the expense ratio.

Given below are a few details of the same.

Meaning of expense ratio

Expense ratio refers to the charges levied by the AMC to manage the funds of the investor. These charges are expressed in the form of percentage and can include the following charges levied by the AMC

• Custodial services
• Record keeping services
• Taxes
• Accounting and auditing fees
• Salariess of the fund manager
• Marketing costs applicable in case of a few AMC which are also referred to as 12B-1 fees.
• Registrar fees
• Advertising fees

These charges, however, do not include the portfolio transaction charges or the brokerage costs, or the initial sales charge. Exit load is a one-time charge paid by the investors at the time of redemption of his/her units. This charge is also not included in the expense ratio,

The expense ratio can also be used as a tool to measure the performance of the fund by the average investors. A fund having a more or a higher expense ratio implies that the cost of managing the fund and its assets is higher. On the other hand, a fund that has a lower expense ratio implies that the cost of managing the assets of the fund is not too high. This may also be indicative of the efficiency of the fund manager. 

The formula for expense ratio

The expense ratio of a fund is expressed in terms of the percentage of the total assets of the fund. For example, if the expense ratio of a fund is 1%, it implies that the fund will use 1% of the fund assets to cover the expenses incurred by the fund annually.

It is also essential here to understand the formula for calculating the expense ratio. As mentioned above, the expense ratio is the cumulation of various expenses incurred by the fund excluding a few charges.

The formula for calculating the expense ratio is given below,

Expense ratio = Total operating expenses of the fund/ Average value of fund assets

Types of expense ratio

There are two types of mutual fund plans offered to Indian investors namely the direct plans and the regular plan. The expense ratio of these plans is different based on the costs involved to manage these funds. 

Regular plans require the help of various intermediaries like registered brokers, distributors, advisors, agents, third party websites etc. to make an investment in the fund. Their expertise is used to manage the portfolio of the investor and make sound investment decisions that can eventually generate higher returns.  When an investment is made through these intermediaries, they earn commission/fees for their services from the mutual fund. This commission/charge is paid out the expense ratio of the fund. This results in an increase in the expense ratio for regular plans. 

A direct plan on the other hand does not have any intermediaries and investment is made by the investor directly with the AMC based on their knowledge and analysis. It could also be through zero fee, zero commission app based investment platforms like Fisdom . Hence, the expense ratio of the direct plan is lower and can eventually result in higher returns for the investor. 

Limits on expense ratio

There are various limits imposed by SEBI to restrict the expense ratio or the total expense ratio (TER) charged by the fund houses. These limits are imposed to safeguard the investor’s interest and ensure the AMCs do not charge an extremely higher expense ratio that may ultimately erode the returns earned by the investor. These limits are further separated based on opened ended and close ended schemes issued by the AMCs.

Following are the limits issued by SEBI in this regard.

1. Open ended equity and non-equity oriented schemes

The limits for open ended equity and non-equity oriented schemes are tabled below,

Assets Under Management Slab (₹Crores)	Total Expense Ratio (TER) limits for Equity oriented schemes (in percent)	Total Expense Ratio (TER) limits for other than Equity oriented schemes (in percent)
On the first ₹500 crore of the daily net assets	2.25	2.00
On the next ₹250 crore of the daily net assets	2.00	1.75
On the next ₹1,250 crore of the daily net assets	1.75	1.50
On the next ₹3,000 crore of the daily net assets	1.60	1.35
On the next ₹5,000 crore of the daily net asset	1.50	1.25
On the next ₹40,000 crores of the daily net assets	Total expense ratio reduction of 0.05 percent for every increase of ₹5,000 crores of daily net assets or part thereof.	Total expense ratio reduction of 0.05 percent for every increase of ₹5,000 crores of daily net assets or part thereof.
On the balance of assets	1.50	0.80

2. Close ended schemes

The limits on TER in case of close ended schemes are,

Type of scheme	Maximum TER (%)
Equity-oriented close-ended or interval schemes	1.25
Other than equity-oriented close-ended or interval schemes	1.00
Index Funds/Exchange Traded Funds (ETFs)	1.00
Fund of Funds investing in actively managed equity-oriented schemes	2.25
Fund of Funds investing in actively managed other than equity-oriented schemes	2.00
Fund of Funds investing in liquid, index and ETFs	1.00

Why is the expense ratio different for direct and regular mutual funds?

The basic difference in the expense ratio of direct and regular mutual fund plans is on account of the agency commission and other ancillary charges that are applicable in the case of regular plans. This extra charge usually accounts for 0.5% to 1.5% of the TER which can significantly impact the returns generated by the fund in the long run.

Direct mutual funds do not have to pay any commission to any external agencies for the investment made by the investors. This reduces the expense ratio and ultimately translates into higher returns in the long term.

Analysis of funds

Let us consider the two funds – one equity and one debt fund scheme to better understand the impact of expense ratio in the ultimate returns earned by the investor.

• ICICI Pru Bluechip Fund

This fund is equity oriented fund and is available in direct plan as well as regular plan. Let us assume an initial investment of Rs. 5,00,000 to better understand the impact on returns due to expense ratio.

Particulars	Direct plan	Regular plan	Difference
Initial investment	Rs. 5,00,000	Rs. 5,00,000	–
Period of investment	5 years	5 years	–
Rate of return	14.46%	13.55%	0.91%
Expense ratio	1.11%	1.74%	-0.63%
Investment value at the end of tenure	Rs.9,82,288	Rs.9,43,856	Rs.38,432

• ICICI Prudential All Season Bond Fund

This is a debt scheme that is available in direct plans and regular plans. The impact of expense ratio on returns is tabled below.

Particulars	Direct plan	Regular plan	Difference
Initial investment	Rs. 5,00,000	Rs. 5,00,000	–
Period of investment	5 years	5 years	–
Rate of return	9.40%	8.63%	0.77%
Expense ratio	0.66%	1.45%	-0.79%
Investment value at the end of tenure	Rs.7,83,532	Rs.7,56,343	Rs.27,189

Conclusion

The expense ratio is an important factor to be considered while making an investment decision. The extent of the expense charged directly impacts the returns earned by the investor. It is therefore essential to compare the expense ratio of not only direct and regular plans of a fund but also compare the TER of various funds and consider other parameters in each category before selecting one apart from other essential parameters. 

FAQs

1. What is the maximum TER that can be charged by any AMC?
A. The maximum TER that can be charged by an AMC is 2.25% on open ended equity oriented schemes.

2. What is usually the difference between the TER of direct mutual funds and regular mutual funds?
A. The usual difference between the TER of direct mutual funds and regular mutual funds is between 0.5% to 1.5%.

3. Does the expense ratio include the exit load on mutual funds?
A. No. Exit loads are a separate charge in the event of premature exit by the investor from the fund. Such a charge is usually from 1% to 2% of the investment value.

4. How does SEBI set the limit on the TER on mutual funds?
A. The limit of maximum TER that is set by SEBI on mutual funds is based on their Assets Under Management.