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:

Total Expense Ratio is calculated by dividing the total expenses incurred on fund management, by the total assets of the fund. The formula is as follows:

Total Expense Ratio = (Total Expenses Incurred / Total Fund Assets) x 100

Total expenses for managing the fund include administration costs, audit costs, transaction costs, legal and accountancy fees, sales and marketing expenses etc.

Total fund assets represent the market value of all the stocks and bonds held by the fund on a given date.

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.

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.