What It Means
The expense ratio is the annual percentage of a mutual fund's total assets charged to cover fund management, administration, and distribution costs. It's deducted daily in small slices from the fund's NAV, so you never see a separate bill; it's already reflected in the returns you see.
How It Works
SEBI caps the maximum expense ratio a fund can charge on a sliding scale that reduces as the fund's assets under management grow, so a smaller fund is allowed to charge more than a very large one in the same category. Actively managed equity funds run the highest caps, followed by hybrid and debt funds, with index funds and ETFs capped lowest since they don't need active stock-picking research. A direct plan of any fund always carries a lower expense ratio than the regular plan of the same scheme, because the regular plan's ratio also pays the distributor's commission.
Warning
A 1% difference in expense ratio sounds small but compounds heavily over a long SIP. On a 20-year equity SIP, the gap between a 1% and 2% expense ratio can be worth several years of extra corpus.