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Business News/ Money / Personal Finance/  What does the total expense ratio mean in mutual funds and why does it vary?
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What does the total expense ratio mean in mutual funds and why does it vary?

SEBI's Total Expense Ratio (TER) regulates operating expenses for mutual funds. A lower TER can increase long-term returns. TER limits vary by fund category, and direct plans have lower TERs than regular plans. TER is an important factor but not the sole criterion for investment selection.

Choose a fund that charges less and enjoys a reputation because of its performance. (REUTERS)Premium
Choose a fund that charges less and enjoys a reputation because of its performance. (REUTERS)

Under the regulatory framework established by the Securities and Exchange Board of India (SEBI) for mutual funds, asset management companies (AMCs) are permitted to levy specific operating expenses, known as the Total Expense Ratio (TER), for the management of a mutual fund scheme. This fee represents a percentage of the fund's daily net assets and is expressed as an annualized percentage of the fund's assets. Since the assets of open-ended funds fluctuate on a daily basis, the proportional TER is factored into the scheme's net asset value (NAV) each business day when the scheme's NAV is disclosed.

Which expenses constitute TER?

The aggregate expenses incurred in operating and overseeing a mutual fund scheme are encompassed within the term “TER". This term represents a proportion of the fund's daily net assets designated for covering the various costs associated with fund management. These expenses encompass:

  • Investment management fees
  • Marketing and distribution fees
  • Administrative fees
  • Custodian fees
  • Audit fees
  • Other operational expenses

When contemplating the selection of a mutual fund, TER emerges as a pivotal consideration, given its potential to exert a substantial influence on your long-term returns. Opting for a fund with a lower TER translates into a larger share of your returns remaining in your pocket.

To find a mutual fund's TER, refer to the Scheme Information Document (SID). The TER assumes a pivotal role in the selection of a mutual fund, as it can exert a substantial influence on your long-term returns. A lower TER translates to a larger portion of your returns remaining with you. Take, for example, the base TER of ICICI Prudential Commodities Fund Direct Plan-Growth will be revised from 0.77 per cent to 0.85 per cent with effect from September 29, 2023.

Here are some guidelines for selecting a mutual fund with a low TER:

Compare TERs: Prior to investing, make sure to compare the TERs of various funds.

Opt for lower TERs: Favor funds with lower TERs.

Explore index funds: Consider index funds, as they often boast lower TERs compared to actively managed funds.

Be careful with funds charging high TERs: Be cautious when encountering funds with elevated TERs, particularly if they are actively managed.

Is there any limit to TER that AMCs can charge?

Presently, the mutual fund expense ratio in India operates with fungibility, signifying that there exists no specific cap on any particular type of allowable expense, as long as the TER remains within the prescribed limit. This grants mutual fund companies the flexibility to allocate their expenses as they deem appropriate, provided that the aggregate expenses do not exceed the prescribed TER.

The slab-based TER structure is applicable across various scheme categories, including equity, debt, hybrid, and solution-oriented funds. This system is strategically crafted to incentivize mutual fund companies to enhance operational efficiency and subsequently pass on the resulting cost savings to investors.

Here is a table illustrating the maximum TER that mutual fund companies can levy under the slab-based TER framework:

Category

Maximum TER

Equity funds

2.5 per cent

Debt funds

2 per cent

Hybrid funds

2.25 per cent

Solution-oriented funds

2.5 per cent

Source: AMFI

It's essential to emphasize that the slab-based TER system exclusively pertains to open-ended mutual fund schemes. Close-ended mutual fund schemes operate outside the purview of the slab-based TER framework. Furthermore, as the assets under management (AUM) grow, the expense ratio tends to decrease.

SEBI has established lower TER thresholds for exchange-traded funds (ETFs) and fund-of-funds (FoFs) in comparison to other mutual fund types. The following represents the maximum TER limits for ETFs and FoFs:

  • ETFs focused on indices and gold: 1 per cent
  • FoFs concentrating on equity schemes: 2.25 per cent
  • FoFs centred on bond funds: 2 per cent

These reduced TER limits are intentionally structured to incentivize investors to consider ETFs and FoFs as they provide a more cost-efficient approach to market investments.

Moreover, it's important to note that interest incurred due to delayed payments to unitholders should not be included in the TER. Additionally, expenses related to investment management, general administration, corporate advertising, and infrastructure costs fall beyond the scope of TER.

Why does TER vary?

Direct plans of mutual funds typically feature lower TERs compared to regular plans. This is primarily because direct plans do not include the commission component payable to distributors, which is a part of regular plans.

Direct plans

Direct plans are mutual fund schemes offered directly to investors by the asset management company (AMC). Investors can access and invest in direct plans through the AMC's website or mobile application.

Regular plans

Regular plans are mutual fund schemes distributed through intermediaries, such as financial advisors or distributors. These intermediaries charge a commission for their services when selling regular plans to investors.

TER discrepancy between direct and regular plans

The variance in TER between direct and regular plans can fluctuate depending on the specific mutual fund scheme. However, typically, the TER difference falls within the range of approximately 0.5 per cent to 1 per cent.

Investing in direct plans allows investors to retain a larger portion of their returns due to the absence of distributor commissions. Also, investing in direct plans is characterized by increased transparency, with investors able to directly access and view the expense ratio of the scheme on AMC's website or mobile app.

Why should you check the TER of a fund?

The TER directly influences a scheme's NAV; a lower expense ratio corresponds to a higher NAV. Consequently, TER assumes a pivotal role as a key parameter when evaluating mutual fund schemes.

While the expense ratio holds significance, it should not serve as the sole criterion for investment selection. It alone does not guarantee superior returns. It's imperative to recognize that choosing a direct plan solely based on a lower expense ratio is insufficient. Investing in mutual funds demands diligent research and a well-structured financial plan to avert potential setbacks and safeguard your financial goals.

 

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Distribution of mutual fund assets across categories
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Distribution of mutual fund assets across categories

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Published: 02 Oct 2023, 11:14 AM IST
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