Expenses ratio
The expenditure ratio, also known as the expense to sales ratio, is a metric that may be calculated to indicate the connection between a single item or a set of expenses and sales. To calculate it, take the total amount of net sales and divide it by a certain cost or collection of expenses. The percentage is used to indicate the expense ratio.
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:
The expenditure ratio determines what proportion of revenue is accounted for by each individual cost as well as by each category of expenses. If the ratio is lower, then the profitability will be greater, and if it is higher, then the profitability will be lower.
When analysing the expenditure to sales ratio, the analyst has to use caution. There are certain expenditures that shift depending on the level of sales (i.e variable expenses). When the sales volume is increased or decreased by a large amount, the ratio for such costs often does not vary much. The ratio shifts noticeably in response to variations in the number of sales because fixed expenditures, such as rent of building and fixed salary, are affected. The ratio is important in reducing costs as well as anticipating those that may occur in the future.
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 expenditure ratio takes into account a variety of fees and costs incurred during the management of the mutual fund. On a day-to-day basis, they deduct this expense from the investors’ contributions to the mutual fund.
On the other hand, they only provide this information to the investors once every six months. Additionally, this will have a significant influence on the amount of money that you bring home.
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
Under Regulation 52 of the SEBI Mutual Fund Regulations, an AMC is responsible for ensuring that all of its expenditures are kept within the prescribed limitations. The total expense ratio (TER) that is permitted by these laws is 2.5% for the first 100 crore of average weekly total net assets, 2.25% for the following 300 crore, 2% for the next 300 crore, and 1.75% for the remaining assets under management (AUM).
The maximum allowable amount for the debt fund is 2.25%. On top of this, the Securities and Exchange Board of India permits all mutual funds to charge an additional 30 basis points as an incentive to penetrate in smaller areas. This was done so that more investors may benefit from investing in mutual funds (B15 Cities). In addition to that, these cities get an extra 20 basis points in the form of exit load costs.
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.