The expense ratio refers to the percentage that indicates the cost you pay to the AMC for managing your investments. In simpler terms, it is the cost incurred for operating and managing a mutual fund. This expense ratio varies across different mutual funds, and it's important to note that you don't pay for it separately. Instead, it's deducted as a percentage of the daily investment value.

For example, if you invest Rs 5000 in a mutual fund with a 2% expense ratio, then (2%/365 = 0.0054%) is deducted daily from the investment. This per-day deduction ensures you're only paying for the period you're invested. Although the expense ratio is small, it reduces your returns gradually. So, a mutual fund with a lower expense ratio is more beneficial since it takes a smaller cut from your returns.

• Expense Ratio = Total expenses / Average AUM
• Total Expense: Includes the AMC's costs such as the fund manager's fee, marketing, distribution expenses, legal, and audit costs.
• Average AUM: The total value of all investor money in that fund.

Now that you understand the expense ratio, let's look at a hypothetical equity mutual fund scheme with AUM (assets under management) of Rs 700 Cr, and total expenses of Rs 14 Cr.

Using the expense ratio formula: Rs 14 Cr / Rs 700 Cr = 2%

This means that, over the course of the year, each investor will pay 2% of the investment value as the expense ratio, which will be deducted daily as long as you're invested in the scheme.

The mutual fund expense ratio consists of various expenses, including:

• Fund Manager's Fee: The fund manager makes decisions that align with the fund's objectives. Actively managed mutual funds include the manager's compensation as part of the expense ratio. Passively managed funds, on the other hand, have lower fees due to less active management.
• Legal/Audit Fee: Mutual funds are regulated by the Securities and Exchange Board of India (SEBI). To comply with regulations, they require ongoing legal services and audits. These costs are also part of the expense ratio.
• Marketing/Distribution Fee: This includes the costs related to marketing, awareness creation, and distribution of the fund through mutual fund distributors. For regular funds, this fee is higher because brokers are compensated, while direct funds usually have lower costs. This is also referred to as the brokerage fee. Therefore, investing in direct funds via platforms like ET Money tends to be cheaper than regular funds.

Let’s understand how the expense ratio works with a simple example. Suppose your mutual fund has an expense ratio of 1.25%, and you invest Rs 1,00,000. If your investment grows to Rs 1,00,500 and Rs 1,00,125 on two consecutive days, here's how the expense ratio would apply each day:

On 1st Jan, you'll pay Rs 3.44, and on 3rd Mar, you'll pay Rs 3.42. Every day, a portion of your corpus is used to cover the expense ratio, which reduces your returns, regardless of whether the returns are positive or negative. This deduction continues as long as you stay invested in the fund.

In summary, the expense ratio represents the costs listed above that reduce your returns over time.

The Securities and Exchange Board of India (SEBI) has set limits on the expense ratio for various mutual funds based on their type and AUM. Here's a look at the limits:

Understanding the expense ratio is essential to managing your mutual fund investments effectively. Here's why it matters:

• A higher expense ratio means lower returns, but it doesn’t necessarily indicate a better mutual fund. Funds with lower ratios can be equally or more successful in generating returns.
• Regular funds tend to have higher expense ratios compared to direct funds because distributors are compensated in regular plans, whereas direct funds have fewer intermediary costs. Choosing direct funds can help you avoid unnecessary expenses.
• If you're comparing two similar funds, the expense ratio can be a deciding factor. For instance, if Fund A and Fund B have similar holdings and objectives, but Fund A has an expense ratio of 1.5% and Fund B has 2%, Fund A is clearly the better choice.
• Expense ratios are especially impactful on debt funds due to their lower returns. A return of 7% with an expense ratio of 2% is reduced to 5%, which might not keep up with inflation.

The expense ratio significantly affects the return on your mutual fund investment as it directly impacts the fund's NAV (Net Asset Value). A lower expense ratio means a higher NAV, leading to better returns for investors.

As a percentage of the total AUM (Assets Under Management), the expense ratio reflects the fund's operating costs. These costs are deducted from the AUM to determine the NAV, which impacts the overall return on your investment.

While many believe that funds with higher expense ratios provide higher returns due to professional management, a fund with a lower expense ratio and expert management can deliver better results.

A high expense ratio can diminish your overall returns, but it’s not the only factor to consider when selecting a fund. Other metrics, such as past performance, fund manager expertise, and XIRR, are also important.

SEBI (Securities and Exchange Board of India) regulates mutual funds and has set maximum expense ratio limits based on the type of fund and AUM.

For equity funds, the expense ratio limit varies between 2.25% for AUM up to Rs 500 Cr and 2% for AUM between Rs 501 Cr and Rs 750 Cr.

Similarly, for debt funds, the maximum expense ratio varies between 2% and 1.75%, depending on the AUM.

Here are a few key points to remember regarding the expense ratio:

• The expense ratio is the cost you pay to the AMC for managing the fund.
• A lower expense ratio is typically better, but make sure it aligns with your investment objectives.
• Regular funds tend to have higher expense ratios than direct plans, and actively managed funds tend to have higher ratios than passively managed ones.
• The expense ratio has a more significant impact on debt funds due to their lower returns, potentially making them insufficient to beat inflation.
• Use the expense ratio to compare mutual funds when choosing the best investment.
• The expense ratio is deducted daily from your investment amount, so you don’t have to pay it separately to the AMC.
• Funds with higher AUM typically have lower expense ratios, as the management costs are spread over more investors.