What is an expense ratio?

The expense ratio is the yearly cost of running a mutual fund, expressed as a percentage of the fund’s assets. It covers the management fee, the registrar, the custodian and the other costs the scheme is allowed to charge. It is taken out of the assets. You do not pay it by cheque. The NAV you are shown is already after it.

A fund that earns 13% before costs and charges 1% does not deliver 13% to you. SEBI sets ceilings that depend on the kind of scheme and how large it is. Those ceilings move when SEBI revises them, so this page does not print a cap as if it were permanent. The number that matters on your fund is the ratio in its current factsheet, inside whatever cap applies today.

Over a long SIP the ratio is not a small print. One percentage point, every year, compounds. It is the difference between two futures that started with the same monthly habit. Direct plans usually cost less than regular plans of the same scheme, because the regular plan includes a distributor’s cost. That gap is an expense-ratio gap. It is not a difference in the shares the fund holds.

The ratio is not a tax. Tax is charged when you sell, on the gain. A lower expense ratio can leave you with a larger gain, and then with a larger tax. The net is still usually better. Do the subtraction in that order: cost first, inside the NAV, tax later, on the sale.

A worked example

The SIP engine does not have a box labelled expense ratio. It has a return. A cost that reduces the return by one percentage point can be shown by running the same plan twice.

₹10,000 a month for 15 years at 12% reaches ₹50,45,760. You invested ₹18,00,000. The same months at one point less reach ₹45,88,576. The difference is ₹4,57,184. That is the rupee cost, on this plan, of giving up one point a year. It is not a statutory fee. It is what the calculator says one point is worth.

If you sell at the end, tax is computed on the gain that remains. At the higher return the engine’s tax is ₹4,06,330. A lower maturity means a lower gain and, often, a lower tax, but the ₹4,57,184 gap is much larger than a small tax difference. Try your own rate on the SIP calculator. The SIP guide and the PPF, ELSS and NPS guide are the places to put that cost next to a lock-in and a tax deduction.

Mistakes people make

• Ignoring the ratio because it is under 1%.
• Comparing a regular plan with a direct plan and blaming the fund manager for the gap.
• Treating the factsheet’s ratio as the tax rate.
• Assuming two funds with the same ratio will earn the same return.
• Forgetting that the ratio is already inside the NAV, and then subtracting it again from a statement return.

What the law is doing

SEBI’s mutual-fund rules cap what a scheme may charge. The Income-tax Act does not give you a deduction for the expense ratio. It taxes the gain you eventually book, under section 198 or section 196 for an equity fund (these were sections 112A and 111A).