What is Total Expense Ratio (TER)

The Total Expense Ratio (TER) indicates the overall cost of operating a scheme or mutual fund. Investors use TER to compare the expenses of one scheme with others similar to it and to understand how these costs affect the returns from the scheme. In mutual funds, TER encompasses all the fees associated with handling, operating, and overseeing the fund, and it is usually presented as a percentage. This article aims to explain what TER represents and how it influences investments in mutual funds.

What is Total Expense Ratio (TER)?

The Total Expense Ratio (TER) is the fee charged by Asset Management Companies (AMCs) to running and managing a mutual fund scheme. It includes all the expenses incurred by the AMC, such as fund management fees, marketing and distribution expenses, legal/audit costs, and other operating costs. The TER is expressed as an annual percentage of the assets under management (AUM) of the scheme.

How does Total Expense Ratio (TER) work?

The fund's management incurs expenses, reflected in the Total Expense Ratio (TER) charged as a percentage of the scheme's total assets. Fund houses declare the Net Asset Value (NAV) after deducting the TER daily, aiding Asset Management Companies (AMCs) in covering management costs.

TER directly impacts your mutual fund returns, where a higher TER implies elevated expenses, consequently affecting fund returns. Consider TER in your evaluation of Mutual Fund performance. For instance, if a scheme has a 20% return and a 2% expense ratio, the net return for the investor is 18%.

Actively managed funds, involving frequent buying and selling to capitalise on market opportunities, generally have a higher TER due to increased transaction and research costs. Conversely, passively managed funds, replicating index performance with infrequent buying and selling, usually have a lower TER, making them an economical choice for investors.

What is Total Expense Ratio (TER) formula?

The formula for calculating the expense ratio is as follows:

Here, Total Costs refer to all costs incurred by the AMC such as fund manager's fee, marketing and distribution expenses, legal/audit costs, etc. Total Net Assets represent the combined market worth of all the assets, such as stocks and bonds held by the fund on a specific date after deducting all liabilities.
For example, if an equity fund has an AUM of Rs. 600 crore and the expenses sum up to Rs. 12 crore, then the expense ratio formula would be (Rs. 12 crore / Rs. 600 crore) * 100 = 2%. So, 2% will be the total expense ratio.

Major costs that add up to TER in mutual funds

Here are some of the major components of total expense ratio that you should know of:

1. Management Fee
   This constitutes a key component of the total expense ratio. In order to meet the cost of running an office, recruiting staff and managing funds, AMCs deduct this fee from the fund corpus. This is higher for active funds than passive funds.
2. Distribution Fee
   This fee is paid to distributors who sell mutual fund schemes to investors.
3. Accounting fee
   This includes expenses related to maintaining records and reports required by regulators.
4. 12B-1 Charge
   This fee is equivalent to the amount spent on advertising each investment fund. It is calculated as a percentage of the fund's net assets and is included in the fund's total cost ratio. The fee is also charged to new investors who allocate funds to the respective mutual fund.
5. Brokerage Fee
   This fee is paid to brokers who execute trades on behalf of mutual funds.
6. All Other Operating Costs
   These include legal fees, audit fees, custodian fees, registrar and transfer agent fees, trustee fees etc.

SEBI limit on TER in mutual funds

Here are the TER Effective from April 1, 2020:

Mutual funds are now permitted to charge an additional 30 basis points (bps) if the new inflows from retail investors from beyond the top 30 cities (B30) are at least 30% of gross new inflows in the scheme or 15% of the average assets under management (year to date) of the scheme, whichever is higher. This is essentially to encourage inflows into mutual funds from tier-2 and tier-3 cities.

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

The TER can have a significant impact on your returns from mutual fund investments. A higher expense ratio means that a larger portion of your returns will be deducted as fees, thereby reducing your overall returns. On the other hand, a lower expense ratio can help you maximise your returns.

Significance of expense ratio in mutual funds

1. Estimating investment costs
   The expense ratio in mutual funds assists investors in understanding the amount they pay for fund management. As the investment value increases, the fund's expense ratio also increases proportionally. This insight allows investors to anticipate changes in their investment value.
2. Evaluating direct plans
   Direct plans typically offer lower expense ratios compared to regular plans due to the absence of third-party involvement in the investment process. This affordability prompts investors to consider more cost-effective alternatives. However, it is essential to evaluate other aspects such as fund performance and risk before finalising investment decisions.
3. Assessing impact on returns
   A higher expense ratio in mutual funds reduces investors' returns on investment over time. Therefore, being aware of the expense ratio in advance helps investors understand the potential erosion of their returns. This awareness enables investors to align their investment goals with their choice of investment instrument more effectively, streamlining the overall investment process.

Why is TER frequently changed by fund houses?

India’s regulatory body for the mutual fund industry, the Securities Exchange Board of India (SEBI), has implemented guidelines governing the maximum expense ratio charged to investors by Fund Houses.

As per SEBI, the Total Expense Ratio (TER) of mutual funds can fluctuate over time, typically on a monthly or quarterly basis. Fund houses adjust the TER for two primary reasons: changes in Assets Under Management (AUM) and to maintain competitiveness in the market. Let us look at these factors in detail:

Impact of AUM changes on TER

AUM, or Assets Under Management, signifies the total value of assets held in a mutual fund's portfolio. SEBI mandates the use of AUM to determine the maximum expense ratio a mutual fund can impose on its investors. Therefore, any alteration in the fund's AUM directly affects the permissible expense ratio. In other words, if AUM increases, the TER decreases and vice-versa.

TER adjustment for competitiveness

India’s mutual fund sector is fiercely competitive, with fund houses vying for investor capital. Besides the multitude of competing funds, performance plays a significant role. Investors may switch from one scheme to another if a mutual fund fails to meet their expectations. Consequently, as the returns of a mutual fund are partly influenced by its expenses, Fund Houses carefully weigh the TER to attract investors. A high TER can impede AUM growth or even lead to negative growth compared to peers in the same category. Fund Houses take this into account when setting the TER for their mutual funds.

Conclusion

In conclusion, understanding the Total Expense Ratio (TER) is crucial when investing in mutual funds. It helps you identify the costs associated with investing in a particular scheme and its impact on your returns. By comparing TERs across different schemes and choosing those with lower ratios, you can maximise your returns from mutual fund investments.

Calculate your expected investment returns with the help of our investment calculators