What Is Total Expense Ratio? Why does it Change?

Investing in mutual funds allows you to leverage the expertise of professional fund managers who manage your money across a diversified pool of assets. However, this convenience comes with a cost — the Total Expense Ratio (TER). This fee encompasses the various expenses incurred in running the fund.

This article looks into the TER and its intricacies. We'll break down its components, understand why it fluctuates, and examine trends impacting TER, including the rising costs of index funds.

Let's begin by taking a look into what the Total Expense Ratio is in the next section.

What Is The Total Expense Ratio?

The total expense ratio (TER) serves as a critical benchmark for evaluating the total costs associated with operating a mutual fund. It covers all the expenses incurred in managing the fund, ultimately impacting your returns as an investor. These costs can be categorized into the following main components:

• Management Fees: This compensation goes to the Asset Management Company (AMC) for their services in managing the fund. The AMC shoulders the responsibility of selecting and overseeing the fund's investments.

• Operating Expenses: These encompass a broader range of costs incurred in running the fund. Examples include administrative costs associated with daily operations, transaction costs related to buying and selling securities within the fund, sales and marketing expenses to promote the fund, audit fees to ensure financial transparency, and custodian fees for safekeeping the fund's assets.

• 12b-1 Fees: Optional marketing and distribution fees charged by some funds (typically for actively managed funds).

The TER is calculated by dividing the fund's total annual expenses by its total assets, expressed as a percentage. This ratio is also referred to as the Net Expense Ratio or the After-Reimbursement Expense Ratio, highlighting that the investor ultimately bears these costs. It's important to note that the fund's Net Asset Value (NAV), which represents the per-unit price of the fund, is determined after deducting these expenses on a daily basis.

How Does the Total Expense Ratio (TER) Work?

The Total Expense Ratio (TER) directly impacts your investment returns in a mutual fund. It functions as a percentage fee levied on the fund's total assets to cover the costs associated with managing the fund.

Here's a breakdown of how TER works:

• Impact on Returns: A higher TER translates to a larger chunk of the fund's returns being used to cover expenses, ultimately reducing your net gain. For example, if a fund delivers a 12% return but has a TER of 2.5%, your actual return would be closer to 9.5%.

• Expense Coverage: The TER is essentially a mechanism for the fund to recoup its annual operational costs. These costs encompass:

• Management Fees: Compensation paid to the fund manager for their investment decisions and oversight.

• Trading Costs: Fees incurred when the fund buys or sells securities within its portfolio.

• Operational Expenses: Costs associated with daily fund administration, legal and audit fees, custodian fees for safekeeping assets, and marketing & distribution expenses.

• Active vs. Passive Management: Actively managed funds, where the fund manager makes investment decisions, typically have higher TERs due to:

• Research Expenses: Actively managed funds require extensive research to identify and analyze potential investments, leading to higher costs.

• Increased Trading: Active management involves frequent buying and selling of securities, resulting in more transaction fees.

• TER Fluctuation: The TER isn't fixed; it can fluctuate based on the fund's performance and expenses. For instance, a rise in the fund's assets can slightly lower the TER as expenses are spread over a larger base. Conversely, a decline in assets can cause the TER to inch upwards.

By understanding how the TER works, you can make informed investment decisions. Choosing a fund with a lower TER allows you to retain a larger share of your returns.

How To Calculate The TER

Here's a breakdown of the formula and a practical example of how to calculate the TER of a Mutual Fund:

TER Formula: The TER is a simple percentage calculation. You can determine it using the following formula:

TER = (Total Fund Expenses) / (Average Net Assets) x 100

Breakdown of Expenses: The "Total Fund Expenses" component encompasses all the costs associated with running the mutual fund. These expenses typically include:

• Administration Costs: Expenses related to daily fund operations.

• Audit Costs: Fees paid to independent auditors to ensure the financial accuracy of the fund.

• Transaction Costs: Fees incurred when the fund buys or sells securities within its portfolio.

• Legal and Accountancy Fees: Costs associated with legal and accounting services.

• Sales and Marketing Expenses: Costs involved in promoting the fund to potential investors.

• Total Fund Assets: This refers to the market value of all the investments held by the mutual fund on a specific date. Imagine it as the total worth of everything the fund owns.

Example:

Let's assume you invest in a mutual fund with total assets of Rs. 500 crore. The fund incurs the following annual expenses:

Administrative Costs: Rs. 1.5 crore

Management Fees: Rs. 2 crore

Other Expenses: Rs. 1 crore

Step 1: Calculate Total Expenses

Total Expenses = Administrative Costs + Management Fees + Other Expenses

= Rs. 1,50,00,000 + Rs. 2,00,00,000 + Rs. 1,00,00,000

= Rs. 4,50,00,000

Step 2: Calculate TER

TER = Total Expenses / Total Assets

= Rs. 4,50,00,000 / Rs. 5,00,00,00,000

= 0.009 or 0.9% of investment

This example demonstrates that the mutual fund in question has a TER of 0.9%. By calculating the TER for different funds, you can identify those with lower expense structures, ultimately maximizing your potential returns.

Why Does the TER Change?

While the TER is a fixed percentage at any given time, it can fluctuate over the long term due to several factors:

• Changes in Assets Under Management (AUM): AUM refers to the total market value of all the investments held by a mutual fund. Regulations set by SEBI establish a connection between a fund's AUM and its maximum allowable expense ratio. Since AUM fluctuates daily due to market movements, adjusting the TER daily is impractical. Instead, fund houses periodically revise the TER to match the prevailing AUM. For example, if the AUM decreases due to a market downturn, the maximum permissible TER for that fund might slightly increase to reflect the fund's current cost structure.

• Market Competition: In the competitive landscape of the Indian mutual fund industry, fund houses often offer lower TERs initially to attract investors and build a solid AUM base. Once the desired AUM level is achieved, the fund house may consider adjusting the TER upwards to a certain extent. This adjustment allows them to recover some of the initial expense concessions while maintaining a sustainable cost structure. This strategy helps fund houses stay competitive while ensuring they can cover operational expenses effectively.

TER Limits for Equity and Debt Funds in India

The expense ratio in India functions as a single, fungible limit. This means there's no restriction on how the TER breaks down into specific expense categories, as long as the total stays within the prescribed limit set by SEBI (Securities and Exchange Board of India) under Regulation 52 of SEBI Mutual Fund Regulations. These limits were revised effective from April 1, 2020, as outlined in the following table:

Assets Under Management (AUM)	Maximum TER (%)	TER for Equity Funds	TER for Debt Funds
On the first Rs. 500 crore	2.25	2.00	1.75
On the next Rs. 250 crore	2.00	1.75	1.50
On the next Rs. 1,250 crore	1.75	1.50	1.25
On the next Rs. 3,000 crore	1.60	1.35	1.10
On the next Rs. 5,000 crore	1.50	1.25	1.00
On the next Rs. 40,000 crore	1.45*	1.20*	0.95*
Above Rs. 50,000 crore	1.05	0.80	0.55

*TER reduces by 0.05% for every additional Rs. 5,000 crore of daily net assets.

Additional Considerations

Mutual funds can charge up to 0.30% (30 basis points) higher TER if at least 30% of new gross inflows come from retail investors beyond the top 30 cities (B30 cities), or if such inflows constitute 15% of the scheme's average year-to-date assets under management – whichever is higher. This incentivizes investments from smaller cities.

Impact on Net Asset Value (NAV)

A lower TER directly translates to a higher NAV for a mutual fund scheme. Therefore, TER remains a crucial factor when selecting a mutual fund, as it directly affects your potential returns.

Transparency in TER Disclosure:

SEBI regulations mandate mutual funds to disclose the TER of all their schemes daily on their websites and the AMFI (Association of Mutual Funds in India) website. This transparency empowers investors to make informed investment decisions.

The Impact of TER on Your Returns

The Total Expense Ratio (TER) in mutual funds can significantly affect investor returns, particularly in the case of actively managed funds. A higher TER translates to lower returns for the investor. However, this impact can be compounded by the size of the funds under management. TER directly influences the Net Asset Value (NAV) of investments. Therefore, it's crucial to compare TERs when analyzing the benefits of different mutual funds.

Consider two mutual funds, Fund A and Fund B, both investing in the same underlying assets and delivering a 15% return before expenses.

Fund A has a TER of 1.5%, while Fund B has a TER of 2%.

After accounting for expenses, your net return would be:

Fund A: 15% - 1.5% = 13.5%

Fund B: 15% - 2% = 13%

As you can see, a seemingly small difference in TER can have a noticeable impact on your long-term returns, especially for investments held over multiple years.

Finding the Right Balance: TER vs. Performance

While a lower TER is generally desirable, it shouldn't be the sole factor driving your investment decisions. Here are some additional considerations:

• Fund Performance: A higher TER fund with a consistent track record of outperforming its benchmark may still be a good option. Analyze the fund's historical returns and compare them to its category.

• Actively vs. Passively Managed Funds: Actively managed funds, which involve a fund manager making investment decisions, typically have higher TERs compared to passively managed index funds. However, actively managed funds can potentially outperform the market, potentially justifying the higher cost.

Taking Control: Strategies to Minimize TER Impact

In addition to the strategies mentioned earlier, here are some further considerations to help you minimise the impact of TER on your returns:

• Consolidate Your Holdings: Review your existing mutual fund investments and consider consolidating them into fewer funds with lower TERs. This can simplify your portfolio management and potentially reduce overall costs.

• Review Periodically: Don't set your investment strategy and forget it. Regularly review your portfolio, including the TERs of your chosen funds. As market conditions and fund performance evolve, you may need to adjust your holdings to maintain a cost-effective strategy.

• Utilize Online Resources: Several online platforms allow you to compare TERs of different mutual funds across categories. Utilize these tools to identify cost-efficient investment options.

Additional Considerations for TER

While TER is a crucial factor, it's not the only cost associated with mutual fund investments. Here are some additional cost elements to be aware of:

• Exit Load: Some funds charge exit loads if you redeem your investment within a specific lock-in period. Factor in these potential charges when choosing a fund.

• Transaction Charges: Certain platforms or brokers may levy transaction fees for buying or selling mutual funds. Choose a platform with minimal transaction fees to maximize your returns.

Conclusion

By understanding the Total Expense Ratio (TER), you're more equipped to make informed investment decisions regarding mutual funds. A lower TER translates to a larger share of your returns, and comparing TERs across different funds allows you to identify cost-efficient options.

Remember, TER is just one piece of the puzzle. Consider factors like the fund's performance history, investment philosophy, and risk profile alongside TER when making your choices. For personalized guidance tailored to your specific goals, risk tolerance, and financial objectives, consulting a professional financial counselor is highly recommended. Their expertise can help you navigate the investment landscape and construct a portfolio aligned with your unique financial aspirations.