Mutual fund investments have costs that are a primary factor for influencing returns. Total expense ratio is one of the most important metrics to consider while investing in mutual funds. This is the annual expense a fund incurs for management and operations. A high TER in mutual funds can decrease profits, while a lower TER helps maximise returns.
Understanding how TER works and its effect on investments will help in making informed decisions. Read further to know everything about TER in detail!
What is TER in Mutual Funds?
An investor must consider many critical aspects before investing in mutual funds. One crucial aspect is the total expense ratio, which accounts for the amount paid to fund managers and other service providers for handling mutual investments. It encompasses everything from management fees and administrative costs to operational and marketing expenses — the total expense is compensated with the TER, which influences investors’ net returns.
Knowing what is TER in mutual funds enables investors to pick cost-effective funds and maximise their long-term returns. The total expense ratio represents the annual cost that an asset management company (AMC) levies to administer and manage its mutual fund. This ratio is disclosed as a percentage of a fund’s total assets under management.
A high TER would mean lesser profit, while a lower TER in mutual funds means that more of the returns remain with the investor. For two mutual funds of the same category that have similar returns, the fund with the lower TER has higher return potential due to lower costs.
For example, if a mutual fund has a TER of 1.5%, it means that for every ₹100,000 invested, ₹1,500 is deducted annually to cover fund management expenses.
How does the TER Works?
In mutual funds, the TER is deducted from the total assets of a fund before calculating the NAV. This means that, as the TER is already added to the NAV, investors do not see it being subtracted directly from their investment holdings. Although the expense ratio affects the payout investors receive, it does so indirectly, as a higher total expense ratio (TER) reduces the final payout. Here is how TER works in mutual funds:
- Pooling of Funds: Mutual funds pool money from numerous investors, combining funds to create a single large lump sum.
- Investment in Securities: The fund house invests these funds in various securities such as shares, bonds, and other financial securities.
- Management Fees: Professional fund managers employed with a fund house (AMC) actively manage the fund’s portfolio by making investment decisions to maximise returns.
- Operational Expenses: Administration, legal, custodian, and marketing costs are incurred to keep the fund running.
- Expense Deduction: The total expenses ratio subsumes all these expenses and is deducted as a single expense ratio proportionally from the fund’s assets.
What Qualifies as a Good Total Expense Ratio (TER)?
A good TER would vary depending on the kind of mutual fund and investment strategy. Normally, funds with lower TER are preferred due to their lower costs and higher returns for investors. However, the acceptable TER would depend on whether the fund is actively managed or passively managed. Here is a comparison of TER among different kinds of funds:
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Equity Mutual Funds
Equity funds are always active management since fund managers research, analyse, and adjust the portfolios to obtain the highest possible returns. The TER of mutual funds in the equity category is usually in the range of 1% to 2%, with 2.25% being the maximum TER that an AMC can charge.
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Debt Mutual Funds
The debt funds concentrate on fixed-income securities and thus involve lesser trading, which results in a lower TER in the range of 0.5% to 1.5%. The maximum TER allowed for a debt fund is 2%.
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Index Funds and Exchange-traded Funds (ETFs)
These funds passively track market indices, eliminating the need for active management. As a result, their total expense ratio is lowest, often between 0.1% and 0.5%.
So, what is a good TER in Mutual Funds? For passively managed funds (index funds and ETFs), a good TER should ideally be below 1%. However, for actively managed funds, a TER below 2% is reasonable. Therefore, investors must always compare TER across similar funds to confirm they are getting cost-efficient options without sacrificing performance.
Formula for Calculating TER
The formula for the total expense ratio is:
TER= (Total Expenses of the Fund/ Total Assets Under Management (AUM)) X 100
For instance, if a mutual fund incurs ₹20 crore in total expenses and has an AUM of ₹1,000 crore, the TER would be:
(20/ 100) X 100 = 2.0%
Steps to Calculate TER
Calculating the Total Expense Ratio (TER) is key to knowing the cost structure of a mutual fund. The TER is defined as a percentage of the total assets of the fund and, therefore, depicts the share of expenses taken off from the fund’s value. Fund houses follow the given steps to calculate TER:
Step 1: Identify Total Expenses
The first step involves determining all costs attributed to managing a fund. These include:
- Fund Management Fees: Charges for managing investments made by fund managers
- Administrative Expenses: Keeping records, ensuring compliance, and reporting
- Custodian and Trustee Fees: Payments made to custodians for asset protection and to trustees for supervision
- Marketing and Distribution Costs: Advertising and promotional costs of a mutual fund
Step 2: Determine Assets Under Management (AUM)
It is the total market value of all assets that a mutual fund scheme is currently managing. As a cornerstone in calculating TER, the expense ratio is charged as a percentage of AUM.
Step 3: Compare the TER with Industry Standards
Lastly, AMCs compare the TER of their mutual funds with similar funds available in the market to check if they are on par with them. A higher TER can reduce returns, so investors will ensure they are getting value for their money.
Key Cost Components Contributing to TER
The total expense ratio of a mutual fund includes all the cost elements associated with fund management, operations, and transaction costs. These costs are deducted from the assets under management in the fund, affecting both the NAV and investor returns. Here are the key cost components defining the total expense ratio meaning:
- Fund Management Fee: This fee is charged by the fund manager for investment decisions, asset allocation, and portfolio management. Actively managed funds typically have higher management fees compared to passive funds.
- Administrative Expenses: This involves record keeping, compliance reporting, audit fees, investor communication and customer service costs. Moreover, it keeps the mutual fund running efficiently.
- Marketing and Distribution Expenses: Incurring promotional expenses of fund houses, which also involve advertising and commissions paid to the distributors, along with commission charges to agents, which are highly charged, mainly when it is actively managed.
- Custodian and Trustee Expenses: This primarily involves maintaining assets in secure custodians and trustees, taking care of the operational affairs of a fund, and following the norms set by various regulators.
- Brokerage Costs: These are fees for buying and selling securities within the fund’s portfolio. The higher the trading activities, the greater the brokerage cost and subsequently, this affects the TER.
SEBI Regulations on TER for Mutual Funds
The Securities and Exchange Board of India (SEBI) regulates the mutual fund’s TER. It deals with price transparency and is concerned with issues of over-pricing for investment by fund houses. Additionally, it helps investors by comparing the cost efficiency at the time of their investment. Here are SEBI’s TER Limits for mutual funds:
- Equity Mutual Funds: SEBI stipulates that the maximum TER that funds with an AUM of less than ₹500 crore can levy will be 2.25%. As the AUM increases, the permissible TER reduces to ensure economies of scale benefit the investors.
- Debt Mutual Funds: The maximum TER for debt funds is 2.00%, as they have a lower management and operational cost as compared to equity funds. For liquid funds, the maximum permissible TER is 1%.
- Index Funds and ETFs: Index mutual funds, and exchange-traded funds cannot charge more than 1% TER.
- Direct vs. Regular Plans: Direct mutual fund plans have a lower TER than regular plans because they do not include distributor commissions. The investor saves costs and enjoys higher net returns by choosing a direct plan.
SEBI has also issued regulations that oblige fund houses to inform investors about changes in TER. The fund house has to notify changes in TER through public notices and fact sheets. This would lead to investment in mutual funds more transparently, allowing investors to compare the TER in mutual funds before making decisions.
Importance of the Expense Ratio in Mutual Fund Investments
The total expense ratio is one of the most critical factors that determine the selection of a mutual fund since it directly affects net returns. A higher TER means lower profits for investors and a reduced amount of retained earnings. The better an investor understands and compares the TER of a mutual fund to another, the more informed their decisions are.
Here is an example of how TER impacts returns:
Two mutual funds have a gross return of 12%. Here are their net returns:
- Fund A has a TER of 2%. This leads to a net return of 10% to the investor.
- Fund B has a TER of 1%. This nets an investor to 11%.
What at first appears as an immeasurably small difference in TER may be large when compounded over long periods and determines the overall accumulation of wealth.
For long-term investors, selecting funds with a low TER will significantly enhance portfolio growth. Furthermore, passively managed funds such as index funds and ETFs generally have a lower TER, thus proving to be cost-effective for investors looking to cut down on expenses.
Why do Fund Houses Frequently Adjust TER?
Fund houses may frequently adjust TER due to changes in market conditions, operational costs, and regulatory requirements. Since TER directly affects the returns of investors in mutual funds, fund houses have to balance their costs with the need to remain competitive. The following factors determine the changes in TER:
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Changes in AUM
A higher AUM enables fund houses to spread the costs over a larger asset base, thus allowing them to reduce TER. Also, if AUM increases, fixed costs remain the same, so the TER goes up to keep profit.
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Changes in Operating Costs
As the operating costs of administration of funds, research, and management of the portfolio increase, so does the TER. Moreover, the implementation of new technologies and automation decreases the operational costs, thus bringing down the TER.
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Competition in the Market
To attract more investors, fund houses may lower the TER on their mutual funds. Passive funds like index funds and ETFs usually have low TER, thereby compelling active funds to lower the fees.
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Regulatory Change by SEBI
SEBI periodically updates the TER limits to provide fair pricing. Any new TER limit set by SEBI will require fund houses to adjust their expense ratios accordingly.
How does TER Impact Mutual Fund Returns?
The TER significantly impacts investors’ net returns. In the case of mutual funds, the total expense ratio is deducted from the fund’s total assets when calculating the Net Asset Value (NAV). A higher TER decreases returns, while a lower TER allows more gains to be passed on to the investor. Therefore, to understand the impact of TER over time, let us compare two investments with a 12% annual return, one with a TER of 2% and another with a TER of 1%.
| Year | Investment Growth (12% Return) | Investment After 2% TER | Investment After 1% TER |
| 1 | ₹1,00,000 | ₹98,000 | ₹99,000 |
| 5 | ₹1,76,234 | ₹1,61,947 | ₹1,68,194 |
| 10 | ₹3,10,585 | ₹2,64,893 | ₹2,85,352 |
From the table, it is evident that a 1% difference in TER significantly impacts returns over 10 years.
Final Words
Understanding the total expense ratio of mutual funds is extremely important before investing. Directly impacting net returns, such a choice helps the investor achieve higher profits. Active funds come with a much higher TER, while alternatives such as index funds or ETFs are more cost-effective investments. So, checking for TER will enable the control of investment costs and the maximisation of returns.
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