SEBI has recently asked mutual funds to reduce their TER or Total Expense Ratio. It may float a discussion paper on the subject. SEBI believes that reducing the TER will ensure that mutual fund investors get a better deal.

What is it?

Mutual funds are professionally managed investment vehicles which help investors to grow their money by investing in financial assets such as equities, bonds, gold and other assets. Mutual fund companies charge a cost to their investors for managing their schemes. This cost is called the Total Expense Ratio.

Mutual funds typically incur two types of expenses. One, there are non-recurring expenses during the launch of a fund, which in India, are usually borne by the fund house and not charged to investors. Two, there are recurring expenses such as the management fee, distributors’ commission, registrar’s fee, trustee fee and marketing expenses. These expenses are total up to the TER, which is expressed as a percentage of assets managed.

In India, the maximum TER that a fund can charge its investors is prescribed by SEBI. Equity-oriented funds are allowed to charge a TER of 2.5 per cent. The cap is set lower for debt and index funds at 2.25 per cent and 1.5 per cent, respectively. SEBI guidelines further set sub-limits for TER based on the size of the assets managed. For equity schemes, fund houses can charge 2.5 per cent for the first ₹100 crore, 2.25 per cent for ₹100 crore to ₹400 crore, 2 per cent on the next ₹400 crore to ₹700 crore and 1.75 per cent on any sums above ₹700 crore.

For debt schemes, the limits are 25 basis points lower in each slabs. An additional 30 basis points can be charged by the mutual fund if 30 per cent or more of their inflows are received from beyond the top 15 cities. Funds can also charge for the service tax on their management fee. Hence, an equity fund with a corpus up to ₹100 crore may end up charging upto 3.3 per cent.

Why is it important?

While mutual funds in the developed world charge a variety of fees and costs to investors, in India, almost all the costs are packed into the single metric of TER (the only cost outside of it is the exit load). The fund manager’s fee and distributors’ commission are two of the main components in the expense ratio. Though the investor does not pay an out-of-pocket commission to the distributor while investing in a mutual fund, the fund company pays it and charges it to investor as a part of the expense ratio.

SEBI has taken various measures to rationalise the expense ratio of mutual funds. In 2012, it made it mandatory for mutual funds to launch ‘Direct’ options in all their schemes. Direct plans are meant for investors who deal directly with the fund house and do not use the services of a distributor. As there are no commissions to be paid under this route, the expense ratios of Direct plans are notably lower than those of Regular plans.

Why should I care?

Your returns from a mutual fund depend on the growth in its Net Asset Value (NAV). This NAV is calculated after reducing the TER from the latest value of the scheme’s portfolio. Hence higher the TER, the lower the money you take home as a fund investor.

While paying a 50 or 100 basis points more to a fund manager may not seem like a big deal when most equity funds are churning out double digit returns, even a small increase in TER has a disproportionate impact on what you finally get from your fund. Take the case of two identical index funds tracking the Nifty50, one with a 1 per cent TER and another with 0.5 per cent. Had you invested ₹1 lakh in each fund 15 years before, the first investment would now be worth ₹8.95 lakh, while the second one would amount to ₹10 lakh. Though both funds own the same stocks, the 50 basis point difference in the expense ratio lowered your kitty by over ₹1 lakh.

Costs are not the only factor to consider while choosing funds. The excess return generated by the fund manager over the long-term is more important. But when choosing between two funds with similar performance, TER is critical. TER is also important in fixed return categories such as debt funds or arbitrage funds.

The bottomline

Don’t pinch pennies but demand value for your money.

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