Can you explain expense ratio in simple language with a numerical example?

To understand expense ratio one needs to understand how a mutual fund company pays for its expenses and earns its profits.

How does a mutual fund earn money?

A mutual fund company works like any other company where they employ people to serve different function. They have associated expenses like:

1. Fund management: They hire fund managers and analysts to decide which instruments to buy/sell. Their salaries have to be paid
2. HR, Legal, Accounting, Operations teams: Every company needs these teams to function.
3. Marketing: They have to run ads to convince people to buy their funds. This requires money.
   
4. Advisor Incentives (Commissions): They need to pay commissions to advisors who recommend their mutual funds.
5. Profits: Finally after removing expenses the mutual fund company has to earn profits for themselves.
6. Other expenses which may not have been covered above.

All the above things have to be taken care of. Who pays for this? Mutual Fund investors pay for this.

Expense Ratio

Lets say you invest Rs 10,000 in a mutual fund. The fund managers invest your money and manage to generate 10% on your investments. So your final value should be Rs 11000, right? WRONG.

The mutual fund company has to pay for its expenses and earn profits. So it will deduct some amount from your final value. Lets say it decides to deduct Rs 110 from your investments. So your final value is:

Rs 11,000 (minus) Rs 110 = Rs 10,890

This Rs 110 deduction is called an expense. How much is the deduction in percentage terms?

(110/11,000) x 100 = 1%

This is called as the expense ratio. So the expense ratio in this case is 1%.

Direct v/s Regular Funds

There are 2 ways to buy mutual funds:

1. Directly from the mutual fund company - this is called Direct Plan
2. From a mutual fund distributor. Some financial advisors are mutual fund distributors - This is called Regular Plan.

In the first case since you have purchased the funds directly from company, the company does not have to pay any commissions. So the expense ratio in the direct plans is lesser than the expense ratio in regular plans.

Real Life Example

Aditya Birla Sun Life Tax Relief 96 is a mutual fund by the company Aditya Birla Sun Life. Here is an example of investing Rs 10,000 in direct and regular plans of this fund.

You can see that the expense ratio of the regular plan (2%) is higher than the expense ratio of direct plan (1%).