Everything you wanted to know about the Total Expense Ratio
Do-it-yourself mutual fund investors spend a lot of time these days researching the “expense ratio” of plans they have shortlisted. Technically called the Total Expense Ratio or TER, this is the amount you pay the house of funds to manage your investment. With the proliferation of passive investment options such as index funds and exchange-traded funds that essentially propagate low-cost investments, here’s a look at TER.
Mutual funds are permitted to charge certain operating expenses for running a mutual fund plan. These fees include sales and marketing/advertising fees, administrative fees, transaction fees, investment management fees, registration fees, custodian fees, audit fees. All of these costs of running and managing a mutual fund are collectively referred to as TER and expressed as a percentage of the daily net assets of the fund. The TER is calculated as a percentage of the plan’s average net asset value (NAV). Thus, the daily net asset value of a mutual fund is disclosed net of fees.
For example, a mutual fund manages total assets worth ₹100 crore. It incurs an administrative fee of ₹75 lakh per year and pays a management fee of ₹85 lakh. Other expenses are ₹40 lakh. Thus, the total expenses are equal to the sum of the administrative fee, management fee and other expenses i.e. ₹200 lakh (₹2 crore). Since TER is equal to total expenses divided by total assets, in this case the TER will be ₹2 crore divided by ₹100 crore, or 0.02 or 2% of the investment.
Currently in India, the expense ratio is fungible i.e. there is no limit on any particular type of allowable expenses as long as the total expense ratio is within the prescribed limit. Effective April 1, 2020, the TER on actively managed equity funds, as per regulations, may be a maximum of 2.25% for the first ₹500 crore of daily average net assets. TER limit is applicable as per AUM slab i.e. 2% on next ₹250 crore, 1.75% on next ₹1,250 crore, 1.6% on next ₹3,000 crore, 1, 5% on the next ₹5,000 crore etc. Above ₹50,000 crore AUM for a fund, the TER limit is 1.05%. This is because the smallest plans manage to charge the highest expenses each year, and as the size of the fund increases, the costs decrease. For debt schemes, the TER is 0.25% lower for all tranches.
The cap of 2.50% for equity plans and 2.25% for loan plans are the base TERs allowed to be charged. Since the SEBI rules allow plans to add some additional expenses to their base TER, some plans may have expense ratios higher than these limits.
The TER is published by all funds in their information sheets. Mutual companies publish the daily TERs of all their plans on their websites in a downloadable format. Changes to TERs are also communicated to investors by mail/SMS.
Why the TER matters
Since the TER is a percentage of the fund’s total assets, it can impact your individual returns as an investor.
A lower TER could mean higher returns. Consider the case of two funds with the same earnings of 16%, but one has a TER of 1% and the other of 2%. Thus, the total returns will be 15% and 14% respectively.
The advent of lower cost passive fund options such as index funds and ETFs has redefined the TER landscape. For example, actively managed large-cap funds have TERs between 1.59% and 2.5%. In comparison, the TERs of large-cap index funds vary between 0.26% and 1.09%. Large-cap ETFs are cheaper with TERs starting at 0.05% and ending at 1.03%. This difference is also prevalent in other categories of equity funds because the fund’s management fees are lower in the case of liabilities.
Given the obvious higher costs, whenever actively managed funds struggle to beat their benchmarks, investors turn to lower-cost options. Passive funds are not designed to beat benchmarks, but they generate returns at a relatively lower cost. Over long periods, a cost difference of 0.50 to 1.00% becomes a significant saving for the investor if the returns of actively and passively managed funds are identical.
Similarly, regular plans and mutual fund direct plans have put TERs in the spotlight. Both the “Direct Plan” and the “Regular Plan” are part of the same mutual fund plan, have the same portfolio, and are managed by the same fund manager, but have different expense ratios. The direct plan has a lower expense ratio than the regular plan because there is no distributor/agent involved. The savings in terms of distribution costs/commissions paid to the distributor/agent are added to the returns of the system and this is seen in the NAVs of the direct and regular plans. TERs for direct plans are typically at least 20-30 basis points lower than those for regular plans.
Note that a high expense ratio does not mean low returns. For example, the best performing equity fund over the past one-year period has an expense ratio of 2.33%, while the worst has an expense ratio of 1.56%. But if you see a continued increase in TER, with no improvement in performance, you should monitor the fund. The TER is incurred regardless of whether or not a program has generated a positive return for its investors. Finally, while the TER is an important criterion when selecting funds, remember that it is not the only one you should use.
The TER can impact your individual returns as an investor
A lower TER could mean higher returns
But a high spend rate does not mean low returns
March 05, 2022