Do-it-yourself mutual fund investors spend a lot of time these days researching the 'expense ratio' of schemes that they have shortlisted. Technically called Total Expense Ratio or TER, this is the amount you pay to the fund-house to manage your investment. With the proliferation of passive investment options such as index funds and exchange-traded funds that essentially propagate low-cost investing, here is a low-down on TER.

Decoding TER

Mutual funds are permitted to charge certain operating expenses for managing a mutual fund scheme. These expenses include sales and marketing/advertising expenses, administrative expenses, transaction costs, investment management fees, registrar fees, custodian fees, audit fees. All such costs for running and managing a mutual fund scheme are collectively referred to as TER and expressed as a percentage of the fund's daily net assets. The TER is calculated as a percentage of the scheme's average Net Asset Value (NAV). Thus, the daily NAV of a mutual fund is disclosed after deducting the expenses.

For instance, an equity mutual fund manages total assets worth ₹100 crore. It incurs administrative expenses of ₹75 lakh per annum and pays management fees of ₹85 lakh. Other expenses amount to ₹40 lakh. So, total expenses is equal to sum of administrative costs, management fees and other expenses i.e. ₹200 lakh (₹2 crore). Since TER is equal to Total Expenses divided by Total Assets, in this case TER will be ₹2 crore divided by ₹100 crore i.e. 0.02 or 2 per cent of investment.

Currently, in India, the expense ratio is fungible, i.e., there is no limit on any particular type of allowed expense 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 regulation, can be a maximum of 2.25 per cent for the first ₹500 crore of net assets averaged daily net assets. TER limit is applicable as per AUM slab i.e. 2 per cent on the next ₹250 crore, 1.75 per cent on the next ₹1,250 crore, 1.6 per cent on the next ₹3,000 crore, 1.5 per cent on the next ₹5,000 crore etc. Above ₹50,000 crore AUM for a fund, TER limit is 1.05 per cent. In effect, the smallest schemes get to charge the highest expenses every year, and as the fund size grows, the costs fall. For debt schemes, the TER is 0.25 per cent lower across all slabs.

The 2.50 per cent cap for equity schemes and 2.25 per cent for debt schemes are the base TERs allowed to be charged. Since SEBI rules allow schemes to add a few extra items of expense to their base TER, some schemes can feature higher expense ratios than those limits.

The TER is published by all funds in their factsheets Mutual fund-houses disclose the daily TERs for all their schemes on their websites in a downloadable format. Changes in TERs are also communicated to investors through mail/SMS.

Why TER is important

Since the TER is a percentage of the total fund assets, it can impact your individual returns as an investor.

A lower TER could mean higher returns. Take the case of two funds with same 16 per cent gains but one has TER of 1 per cent and other 2 per cent. So, the total returns will be 15 per cent and 14 per cent respectively.

The advent of lower-cost passive fund options such as index funds and ETFs has redefined the TER landscape. For instance, actively managed large-cap funds have TERs ranging between 1.59 per cent and 2.5 per cent. In comparison, TERs of large-cap index funds range between 0.26 per cent and 1.09 per cent. Large-cap ETFs are more cheap with TERs starting from 0.05 per cent and ending at 1.03 per cent. This difference is also prevalent across other equity fund categories because the fund management fee is lower in case of passives.

Given the obvious higher costs, every time actively-managed funds struggle to beat their benchmarks, investors turn towards lower-cost options. Passive funds are not designed to beat benchmarks, but they generate returns at a relatively lower cost. Over long periods, a 0.50-1.00 per cent cost difference becomes a large saving for investor if actively-managed and passively-managed fund returns are identical.

Similarly, regular plans and direct plans of mutual funds have put TERs in spotlight. 'Direct plan' and 'Regular plan’ are both part of the same mutual fund scheme, have the same portfolio and are managed by the same fund manager, but have different expense ratios. Direct plan has lower expense ratio than the regular Plan, as there is no distributor/agent involved. The saving in terms of distribution cost/commissions paid out to the distributor/agent, is added back to the returns of the scheme and this can be seen in the NAVs of direct and regular plans. The TERs of direct plans are usually lower by at least 20-30 basis points as compared to those of regular plans.

Do note that a high expense ratio does not mean low returns. For instance, the best performing equity fund in the last 1 year period has an expense ratio of 2.33 per cent while the worst has an expense ratio of 1.56 per cent. But if you notice a continuous increase in TER, without improvement in the performance, you should monitor the fund. TER is incurred irrespective of whether a scheme has generated a positive return for its investors or not. Last, while the TER is an important criterion when you select funds, remember it is not the only one you should use.

Take note
TER can impact your individual returns as an investor
A lower TER could mean higher returns
But a high expense ratio does not mean low returns