What is Total Expense Ratio in mutual funds?

Total Expense Ratio (TER) plays an important role in determining the net returns you earn from your mutual fund investments. TER represents the cost of managing a mutual fund, expressed as a percentage of its total assets. This fee directly influences the net returns realized by investors. This article will give you a comprehensive idea of TER, its components, and its significance in the context of mutual fund investments.

• Table of contents

1. What is a Total Expense Ratio (TER)?
2. How does Total Expense Ratio in mutual funds work?
3. How to calculate Total Expense Ratio
4. Key components of TER
5. SEBI limit on TER in mutual funds
6. What is the impact of TER on returns in mutual funds?
7. Limitations of the total expense ratio in mutual funds

What is a Total Expense Ratio (TER)?

The Total Expense Ratio (TER) encapsulates the aggregate fees levied by Asset Management Companies (AMCs) for the operation and administration of a mutual fund scheme. It encompasses the entirety of expenses borne by the AMC, including fund management fees, distribution costs, legal and audit charges, and other operational outlays.

The TER is represented as an annual percentage of the scheme's assets under management (AUM), providing investors with a clear indication of the costs associated with their investment.

Calculated by dividing the fund's total expenses by its total assets, the TER is also commonly referred to as the net expense ratio or the expense ratio after reimbursement. This ratio helps investors comprehend the impact these costs can have on the net returns generated by the scheme.

How does Total Expense Ratio in mutual funds work?

The specific TER value for a mutual fund can be influenced by its size or scale. Funds with a smaller pool of assets under management often need to allocate a proportionally larger share toward effective management and oversight. Consequently, this leads to a higher relative cost burden compared to the overall fund size.

Conversely, mutual funds, boasting a substantial asset base, can spread their expenses over a larger pool of investments. This may result in a lower TER, showcasing an inverse relationship between the expense ratio and the fund's size.

Actively managed funds, characterized by frequent buying and selling of securities to capitalize on market opportunities, typically exhibit higher TERs due to increased transaction costs and research expenditures. In contrast, passively managed funds, designed to replicate the performance of an index, subject to tracking error, with less frequent trading activity, generally have lower TERs, making them a more cost-effective option for investors.

How to calculate Total Expense Ratio

The Total Expense Ratio (TER) is determined through a straightforward calculation:

TER = (Total Expenses Incurred / Total Net Assets) * 100

In this formula:

Total expenses incurred: This encompasses all costs borne by the Asset Management Company (AMC), including the fund manager's compensation, marketing and distribution expenditures, legal and audit fees, and other operational expenses.

Total net assets: This represents the aggregate market value of all assets held within the fund, such as stocks and bonds, on a specific date, after deducting any liabilities.

To illustrate, consider an equity fund with assets under management (AUM) totalling Rs. 600 crore and expenses amounting to Rs. 12 crore. Applying the TER formula, we have:

(Rs. 12 crore / Rs. 600 crore) * 100 = 2%

Therefore, the total expense ratio for this fund would be 2%.

Key components of TER

Management fee: This represents a core element of the TER, covering the costs incurred by the Asset Management Company (AMC) for running its operations, including office space, staffing, and fund management.

Distribution fee: This fee is paid to distributors or intermediaries who facilitate the sale of mutual fund schemes to investors.

Administrative costs: These encompass a range of expenses associated with managing a mutual fund, such as marketing fees, legal and custodian fees, and registration charges.

Maintenance and operational costs: This category includes expenses incurred for record-keeping, customer support, and other administrative tasks necessary for the smooth functioning of the fund.

Brokerage fee: This fee is paid to brokers who execute trades on behalf of the mutual fund.

Other operating costs: This broad category encompasses various expenses such as legal and accounting fees, sales and marketing costs, and other operational overheads, including rent, utilities, and telecommunications.

SEBI limit on TER in mutual funds

The Securities and Exchange Board of India (SEBI), through Regulation 52 of the SEBI Mutual Fund Regulations, effective from April 1, 2020, has established specific limitations on the TER that mutual funds can charge investors.

TER limits for equity funds:

The maximum permissible TER for equity funds is structured as follows:

For the first Rs. 500 crores of daily average net assets: 2.25%

On the next Rs. 250 crore: 2.00%

On the next Rs. 1,250 crore: 1.75%

On the next Rs. 3,000 crore: 1.60%

On the next Rs. 5,000 crore: 1.50%

On the next Rs. 40,000 crore: Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crore of daily net assets or part thereof.

On balance of assets: 1.05%

TER limits for debt funds

The maximum permissible TER for debt funds is structured as follows:

For the first Rs. 500 crores of daily average net assets: 2.00%

On the next Rs. 250 crore: 1.75%

On the next Rs. 1,250 crore: 1.50%

On the next Rs. 3,000 crore: 1.35%

On the next Rs. 5,000 crore: 1.25%

On the next Rs. 40,000 crore: Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crore of daily net assets or part thereof.

On balance of assets: 0.80%

TER calculation: An example

To demonstrate the calculation of the TER, let's consider a hypothetical scenario where you've invested in a mutual fund with total assets valued at Rs. 100 crores. This fund incurs annual administrative expenses of Rs. 25 lakhs, pays management fees of Rs. 35 lakhs, and has other miscellaneous expenses amounting to Rs. 20 lakhs.

The TER would be computed as follows:

Total Expenses = Administrative Costs + Management Fees + Other Expenses

= Rs. 25,00,000 + Rs. 35,00,000 + Rs. 20,00,000

= Rs. 80,00,000

TER = (Total Expenses / Total Assets) * 100

= (Rs. 80,00,000 / Rs. 100,00,00,000) * 100

= 0.8%

In this example, the total expense ratio for the mutual fund would be 0.8% of your investment. This indicates that for every Rs. 100 invested in the fund, Rs. 0.80 would be allocated towards covering its operational expenses.

What is the impact of TER on returns in mutual funds?

The Total Expense Ratio (TER) can exert a notable influence on the returns you realize from your mutual fund investments. A higher expense ratio signifies that a greater portion of your returns will be utilized to cover fees, consequently diminishing your overall gains. Conversely, a lower expense ratio allows for a larger share of the returns to accrue to your investment.

Limitations of the total expense ratio in mutual funds

While the TER provides a valuable overview of the recurring costs associated with managing a mutual fund, it's important to recognize that it is not the only thing to be considered while selecting a scheme. Here are some of its limitations:

• 1. Limited insight: A lower TER may be preferred, but some actively managed funds with higher TERs might outperform lower-cost funds due to better management or strategy.
• 2. Lack of transparency: The breakdown of the specific components within TER (e.g., marketing, fund manager salaries) may not always be clearly detailed. Investors might not fully understand how their money is being spent

Conclusion

The Total Expense Ratio (TER) serves as a crucial yardstick for evaluating the cost efficiency of mutual fund investments. While actively managed funds may offer the allure of higher returns, they often come with higher TERs. Conversely, passively managed funds, designed to replicate index performance, generally exhibit lower TERs, making them a cost-effective option for investors seeking to track market benchmarks.

Remember, the TER is just one piece of the puzzle when evaluating mutual funds. It's essential to consider other factors, such as the fund's investment objectives, past performance, risk profile, and the fund manager's track record.

FAQs:

What is a good expense ratio for a mutual fund?

A good expense ratio is subjective and depends on the type of mutual fund and its investment strategy. However, as a general guideline, a TER below 1% for actively managed equity funds and below 0.5% for passively managed index funds is considered reasonable. It's essential to compare the TER of similar funds within the same category to assess their cost-effectiveness.

What is the total expense ratio (TER) and its relation to NAV?

The TER represents the annual percentage of a mutual fund's assets used to cover its operating expenses. These expenses are deducted from the fund's assets daily before calculating the Net Asset Value (NAV). A higher TER leads to a lower NAV, impacting your investment returns.

How is the total expense ratio charged?

The TER is not charged directly to investors as a separate fee. Instead, it is reflected in the daily NAV calculation. The fund's assets are reduced by the proportionate TER amount each day, effectively incorporating the expense into the fund's performance.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.