Total Expense Ratio (TER)_ Meaning & Calculation in Mutual Funds

When you invest in Mutual Funds, you are putting your trust in professional fund managers who make investment decisions on your behalf. However, managing a Mutual Fund involves certain expenses that are transferred to you, the investor, in the form of a fee known as the Total Expense Ratio (TER).

In this blog, we will explore what TER is, how it functions and the reasons why it is constantly adjusted. We will also discuss the increasing TER of Index Funds and the future trends for Mutual Fund Expense Ratios.

Understanding Total Expense Ratio

Total Expense Ratio (TER) estimates the total expenses involved in managing a Mutual Fund. Asset Management Companies (AMCs) are responsible for managing Mutual Funds. This fund management involves various expenses such as administration costs, transaction costs, sales and marketing expenses, audit fees, custodian fees and more. All these expenses collectively form the fund’s Total Expense Ratio.

How does TER work?

TER is a fee, which includes the expenses of managing a Mutual Fund. It is calculated as a percentage of the total assets held by the fund. Fund houses declare the Net Asset Value (NAV) of the fund after deducting TER daily. TER impacts the overall returns generated by the fund. A higher TER leads to higher expenses, affecting the fund's returns. Therefore, it is important to consider the TER while assessing the fund’s performance. For instance, if a fund delivers a return of 25% and has an Expense Ratio of 4.25%, the net return for the investor would be 20.75%.

Actively managed funds generally have higher TERs than passive funds. Active fund managers frequently buy and sell securities to capitalise on market opportunities, leading to increased transaction costs and research expenses. In contrast, passive funds replicate the performance of Index Funds, resulting in lower TERs.

Total Expense Ratio formula and calculation:

TER known as Total Expense Ratio, is defined as the percentage of a mutual fund's assets that go toward the fund's expenses, such as management fees, administrative costs, and other operating charges. It is a key metric to evaluate the cost of investing in a mutual fund.

TER = Total Expenses of the Fund/ Total Fund Assets)* 100

Let us take an example to understand the concept better:

Suppose the total annual expenses of the fund are ₹2 crore and the total fund assets are ₹500 crore

Then TER = (₹2,00,00,000 / ₹5,00,00,00,000) × 100 = 0.40%

So, the Total Expense Ratio is 0.40%. This means for every ₹100 invested, ₹0.40 goes towards managing the fund annually.

What are the Components Of Total Expense Ratio?

Here's a breakdown of the key components:

• AMC Fee: Core fee charged by the fund house to manage your investments.

• Transaction Cost: Brokerage or other charges incurred while buying/selling securities.

• Compliance Costs: Regulatory filing fees, audit costs, and legal charges.

• Distribution Commission: Paid to distributors or agents selling the mutual fund scheme.

Note- These are proportionally deducted from the overall fund corpus and reflected as a percentage — the TER.

Reasons for frequent changes in TER

Mutual Fund companies, adhering to the regulations laid down by the Securities Exchange Board of India (SEBI), have the authority to modify the Total Expense Ratio (TER) of funds. This adjustment occurs monthly or quarterly due to two factors: fluctuations in AUM (Assets Under Management) and competition within the market.

• Impact of changes in AUM on TER: AUM signifies the total value of assets in a Mutual Fund portfolio. SEBI has stated that the maximum Expense Ratio decided by a fund can vary according to the AUM of the fund. Given the daily fluctuations in AUM due to market dynamics, it is difficult to alter the TER daily. As a result, fund houses periodically revise the TER. For instance, if a fund experiences a decline in AUM due to a market correction, the maximum TER may increase. This adjustment aligns the TER with the prevailing AUM of the fund. 

• Market competition: The Indian Mutual Fund Industry is extremely competitive, with numerous fund houses offering multiple investment choices. Fund houses aim to maintain competitive TERs to attract more investors. Initially, they may introduce lower TERs to draw a larger investor base to strengthen the fund's AUM. Once the AUM achieves a desired level, the fund house may raise the TER to compensate for the reduced Expense Ratio. This approach enables fund houses to survive competition while generating enough revenue to cover their expenditure.

Major Costs That Add Up to TER in Mutual Funds

Below are the major expenses that make up the TER:

1. Fund Management Fee: It is paid to the Asset Management Company (AMC) for managing your investment.

2. Administrative Expenses: These expenses include salaries, office expenses, customer service, etc.

3. Registrar and Transfer Agent Fee: This cost is charged for maintaining investor records and transaction processing.

4. Marketing and Distribution Fee: This includes the costs for promoting the fund and paying commissions to distributors.

5. Legal and Audit Fees: It covers the charges for legal compliance and annual audits.

6. Custodian Charges: It includes fees for the safekeeping of securities by a custodian.

All these combined are reflected in the TER and directly reduce the fund's NAV.

Suggested measures to tackle frequent Total Expense Ratio adjustments:

Changes in the Total Expense Ratio (TER) can lead to frustration among investors. Regulatory bodies such as SEBI can implement some strategies for a more stable environment for investors. These measures include:

• Reducing TER hikes: SEBI can introduce limits that allow AMCs to increase TER only once or twice in a fiscal year. This will prevent disturbances caused to investors and their financial plans.

• TER modification limits: Another approach involves specifying the extent to which AMCs can alter TERs in a single modification. This would give a certain degree of predictability to investors regarding their funds. 

• Approval protocol: Fund houses, in collaboration with SEBI should have an extensive approval process in place for introducing any TER changes. This will help justify the reasons for TER adjustments and ensure that they align with the interests of the investors.

• Exit alternatives: SEBI should allow investors to exit from schemes without paying exit charges, if they feel stuck due to significant increase in TERs. This would give investors more flexibility, reducing the impact of unforeseen changes in TER.

Investors should understand that TER is important for a Mutual Fund investment. It reflects the overall expenses incurred on managing funds. TER directly impacts the fund’s returns. Active funds have higher TERs, reflecting the costs involved in active portfolio management.

The reasons behind changes in TER are many and are usually driven by fluctuations in AUM and intense competition in the market. These changes can lead to frustration among investors.

To address these concerns and provide more stability to investors, regulatory authorities like SEBI should consider putting certain measures in place. These include restricting TER hikes, setting limits on TER modifications, introducing an approval protocol for TER changes and offering exit alternatives to investors who are affected by significant increase in TERs.

What Are the Limitations of the Total Expense Ratio (TER)?

While TER helps compare mutual funds, it has a few limitations:

• Doesn't Reflect Actual Profitability: It means that a low TER doesn’t guarantee high returns or performance.

• Ignore Exit Loads: TER doesn’t include charges like exit loads or penalties for early redemption.

• Performance vs Cost: Sometimes, funds with slightly higher TERs may deliver better performance due to skilled fund management.

• Varies by Fund Type: TERs for actively managed funds are higher than index or passive funds, so it’s not always an apples-to-apples comparison.

How Does the Total Expense Ratio Impact Fund Return?

A high TER reduces your returns because it is deducted from the fund’s earnings. Here's how:

• If your mutual fund earns 12% annually and the TER is 2%, your effective return is only 10%.

• Over long-term investments, even a 1% difference in TER can impact your wealth significantly due to compounding.

• Funds with lower TER often outperform over time, especially in debt or index funds where margins are thinner.

Always compare TERs before choosing a fund to ensure better cost-efficiency and value.