To understand expense ratio one needs to understand how a mutual fund company pays for its expenses and earns its profits.
A mutual fund company works like any other company where they employ people to serve different function. They have associated expenses like:
All the above things have to be taken care of. Who pays for this? Mutual Fund investors pay for this.
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%.
There are 2 ways to buy mutual funds:
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%).
Sachin Shah is a 30 year old Senior Software Engineer, working at an IT services company in Bengaluru. He and his wife want to plan for their retirement and also want to save for their child's education, wedding and for buying a car.View Case Study