All services attract charges and, in this regard, mutual funds are no different. They levy a fee to manage investors’ money. This fee comprises administrative expenses such as fund management costs, commissions, or selling and promotion dues etc,. All charges combined are categorized under one head known as the Total Expense Ratio (TER). The TER is an important figure one must consider when investing in mutual funds.

What is Total Expense Ratio?

The TER is the cost of managing a fund that is expressed per unit. Usually stated as a percentage of the assets under management, the TER accounts for all the expenses incurred to run the show. These costs that the fund incurs is recovered from the investor. A fund’s net asset value is reported only after deducting these expenses on a daily basis.

Components of TER

Three major costs add up to TER for mutual funds. These include:

1. Management fees

   A mutual fund’s performance is closely tied to its fund manager. The strategy and decision-making abilities of the fund manager typically dictates the mutual fund’s revenue and returns. Therefore, a fund house must compensate their managers for their expertise.

2. Administrative costs

   Managing a mutual fund entails various costs such as registrar and transfer fees, custodian charges, legal and audit fees , management expenses, advertising and marketing fees etc. All these tiny costs contribute significantly to a fund’s expenses.

3. Distribution fees

   Some mutual funds also charge distribution fees as commission for selling mutual fund units This added component would be included in the fund’s Regular Plan TER.

What impact does the expense ratio have on returns?

The TER you incur on a mutual fund investment indicates the amount you would need to pay to manage your portfolio. Since the TER is a percentage of the total fund assets, it could impact your individual returns as an investor.

For instance, if a mutual fund has a TER of 2%, and makes a profit of 15%, the total returns on your investment would come to 13%. A lower TER could mean a higher profitability rate.

However, a high expense ratio does not necessarily mean low returns since the amount depends on the funds under management. Yet, keeping an eye on the TER is essential because it impacts the Net Asset Value (NAV) of the investments directly.

Compare the TER on different funds to ensure the cost does not outweigh the mutual fund benefits. The expense ratio can also help you differentiate between an actively managed and a passively managed fund. Typically, actively managed funds have a higher TER than passively managed funds.

SEBI limit on TER

The Securities and Exchange Board of India (SEBI) has defined certain limitations on the TER that a mutual fund can charge an investor. These are covered under Regulation 52 of SEBI Mutual Fund Regulations. Effective April 1, 2020 the TER of various categories stand revised and which are as follows.

1. TER on Equity funds

   For equity schemes that are actively managed, the regulation permits a maximum TER of 2.25 % for the first Rs.500 crore of net assets averaged daily net assets. TER limit applicable per AUM slab as per below,

   on the first Rs. 500 crores	2.25%
   on the next Rs. 250 crores	2.00%
   on the next Rs. 1,250 crores	1.75%
   on the next Rs. 3,000 crores	1.60%
   on the next Rs. 5,000 crores	1.50%
   On the next Rs. 40,000 crores	Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets or part thereof.
   Above Rs. 50,000 crores	1.05%

2. TER on Debt funds

   The limit for debt fund is 2.00%. and the TER limit per AUM slab is applicable as per below,

   on the first Rs. 500 crores	2.00%
   on the next Rs. 250 crores	1.75%
   on the next Rs. 1,250 crores	1.50%
   on the next Rs. 3,000 crores	1.35%
   on the next Rs. 5,000 crores	1.25%
   On the next Rs. 40,000 crores	Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets or part thereof.
   Above Rs. 50,000 crores	0.80%

3. In addition to the above, the following costs or expenses may be charged to the Schemes,
   1. Expenses in case of inflows from retail investors from cities beyond Top 30 cities charged proportionately under Regulation 52(6A)(b)
   2. Additional expenses permissible under Regulation 52(6A)(c) towards various permissible expenses with scheme charging exit load.

To understand how to calculate the expense ratio, take a look at the illustration below:

An equity mutual fund manages total assets worth Rs.100 crores. It incurs administrative expenses of Rs.75 lakhs per annum and pays management fees of Rs.85 lakhs. Other expenses amount to Rs.40 lakhs.

The total expense ratio would be as follows:

Comparative analysis

Take the total expense ratio of mutual funds into consideration when evaluating your investment options.

Takeaway

Expense ratio is important to consider while selecting a mutual fund scheme. However, financial experts opine that one must look at the expense ratio in conjunction with other criteria. These include the mutual fund’s track record and its consistency of returns.

For example, the TER for an aggressively managed active fund could be high, but the returns generated could compensate for the high expense. Take into account your investment profile, risk appetite, time horizon and financial goals to invest in the right mutual fund. Research and analyze the various options available to make investments in a relevant mutual fund.