What Is Expense Ratio in Mutual Funds, And How Is It Calculated?

April 25, 2023 Mutual Fund

The popular adage, “There is no such thing as a free lunch,” holds true even when it comes to investing in mutual funds.

To run a mutual fund house and schemes, several costs are involved such as investment management fees, brokerage on buying and selling securities, registrar & transfer fees, custodian fees, legal fees, audit fees, sales & marketing /advertising expenses, administrative expenses, and so on. These costs are levied on the mutual fund scheme as a percentage of its daily net assets and are referred to as the Total Expense Ratio (TER).

How is the Total Expense Ratio or TER calculated?

The formula used to calculate TER is as follows:

Total Expense Ratio (TER) = (Total Expense of the Scheme during the period / Total Scheme Assets) x 100

The capital market regulator, the Securities and Exchange Board of India (SEBI), which also regulated mutual funds, has made it mandatory for mutual fund houses to disclose the TER of all schemes on a daily basis on their websites as well as the Association of Mutual Funds in India’s (AMFI’s) website.

How much Total Expense Ratio (TER) can a mutual fund scheme charge?

Moreover, depending on the types of mutual fund schemes, i.e. equity-oriented or debt-oriented, Assets Under Management (AUM) and whether the scheme is actively managed or passively managed, SEBI has prescribed guidelines on the maximum TER that can be levied by the scheme.

The current TER limits for actively managed mutual fund schemes are as under:

Table 1: Mutual Fund TER limit for actively managed equity and debt schemes

(Source: www.sebi.gov.in) 

In the case of passively managed mutual fund schemes, the TER limits are currently as under:

Table 2: TER limit for passive mutual fund schemes

(Source: www.sebi.gov.in) 

Irrespective of whether you invest a lump sum or through the Systematic Investment Plan (SIP) mode, the aforesaid Total Expense Ratio limits apply. As long as the TER is well within the prescribed limit, it is fungible.

Until March 2023, mutual funds were allowed to charge up to 30 basis points (bps) more if the new inflows from retail investors were from beyond the top 30 cities (called the B30 cities). This was done to encourage flow from the Tier-2 and Tier-3 cities. But on finding flaws and inconsistencies such as “splitting of transactions”, “churning of investments”, and “the way incentives were calculated” on the part of the fund houses, SEBI temporarily disallowed fund houses from charging additional expense ratio from the B30 cities.

How important is Total Expense Ratio when choosing a mutual fund scheme?

The Total Expense Ratio or TER is deducted from the mutual fund scheme’s Net Asset Value (NAV). In other words, the scheme’s daily NAV is TER-adjusted. Thus, as an investor, you do not pay for expenses ratio separately. Yet keep in mind, that the Total Expense Ratio is an important parameter when investing in mutual funds. Lower the expense ratio of a mutual fund scheme, the impact on its NAV will be lower.

Having said that, the Total Expense Ratio is not the only parameter to select winning mutual funds. A host of quantitative and qualitative parameters, such as the following need to be evaluated:

• Returns over various time frames (6-months, 1-year, 2-year, 3-year, 5-year, 10-year, since inception)
• Performance across market phases (i.e., bull and bear phases)
• Risk ratios (Standard Deviation, Sharpe, Sortino, etc.)
• The expense ratio of the scheme
• Portfolio characteristics (the top-10 holdings, top-5 sector exposure, how concentrated/diversified is the portfolio, the market capitalisation bias, the style of investing followed – value, growth, or blend, the portfolio turnover. In the case of debt funds, the average maturity, modified duration, and the quality of debt papers)
• The quality of the fund management team (the experience of the fund manager, the number of schemes he/she manages, the track record of the mutual fund schemes under his/her watch, the experience of the research team)
• And the overall efficiency of the mutual fund house in managing investors’ hard-earned money (i.e., the proportion of AUM actually performing)

Moreover, it makes sense to understand the investment ideologies, processes and systems followed at the fund house.

Just the Total Expense Ratio can never be the deciding factor to pick the best mutual fund schemes. Moreover, the Total Expense Ratio of a respective fund ideally should be compared with the TER of other schemes within the category and sub-category of mutual funds; it cannot be looked at in silos.

[Read: Does the Expense Ratio Matter to Select the Best Mutual Fund Schemes?]

The Total Expense Ratio levied by a mutual fund scheme needs to be justified by its performance. Want to know which are the 5 Best Active Equity Mutual Funds with Low Expense Ratios and High Returns? Click here.

Choose Direct Plan for Low Expense Ratio

If you are looking to benefit from a lower Total Expense Ratio, consider investing in Direct Plans of mutual fund schemes instead of the Regular Plan.

Direct Plans were introduced in January 2013 after SEBI made it mandatory for all mutual funds to offer them an option for investors. The difference between the two types of plans is that when you opt for the Regular Plan, you transact through an intermediary, whereas in the case of Direct Plans, you purchase units directly from the asset management company or through mutual fund platforms encouraging Direct Plans. The Regular Plan charges a higher expense ratio compared to the Direct Plan to incentivise the intermediary.

According to our estimates, every 0.25% difference in the expense ratio of a scheme could fetch you Rs 4.5 lakh in 20 years. So, investing in Direct Plans of mutual fund schemes is the best way to keep costs low without compromising on potential gains.

[Read: How To Invest In Direct Plans of Mutual Funds Online & Offline]

Besides, to ensure that you own suitable mutual fund schemes in your portfolio, consider your risk profile, investment objectives, financial goals, and time in hand to achieve the envisioned goals. Be a thoughtful investor.

This article first appeared on PersonalFN here