Total Expense Ratio (TER) in Mutual Funds

There’s no free lunch in this world, and mutual funds are no different.

Although an excellent investment option for everyone, mutual funds are not free. Investors don’t realise this because the ‘total expense ratio’ or mutual fund fee is not charged directly to investors.

The TER or Total Expense Ratio (also called just ‘expense ratio’) is deducted from the money you invest and is expressed in percentage terms. 

Let’s understand the total expense ratio in detail. We also discuss its components, calculation, and impact on mutual fund performance.

What is the Total Expense Ratio (TER)?

The total expense ratio indicates the fee mutual fund schemes charge you for managing your money. 

For example: If a mutual fund scheme has an expense ratio of 2%, they will charge you 2% of the amount they manage for you.

But this doesn’t mean that if you invest ₹10,000 in the scheme, they will deduct Rs. 200 from your investment on day 1 and invest the remaining Rs. 9,800. Instead, the 2% expense ratio is charged over a year on a daily basis.

To understand this better, let’s suppose you invest ₹10,000 in a mutual fund for 10 days, and the mutual fund’s expense ratio is 2%. We will also assume that the mutual fund gives you a 1% return every day for 10 days. 

Here’s how the expense ratio charge is calculated and deducted:

As you can see, the expense is charged on a daily basis. So, if your investment value is Rs. 10,000 on a given day, the expense is deducted for the day as Rs.10,000* (2%/365) which is about Rs. 0.55.

Your scheme’s daily NAV is net of the expenses. Simply said, the value of your mutual funds is calculated after their expenses are taken into account.

Now that we know how the expense ratio is deducted let’s look at the components of the expense ratio.

Constituents of the Total Expense Ratio

The total expense ratio majorly includes the following:

• Investment management and advisory fees: These primarily include the salary of the fund manager/fund management team. For passive funds, these are lower than actively managed funds because the role of fund management is limited in passive funds.
• Administrative expenses: These are most of the operational expenses like RTA fee, custodian fee, legal fee, audit and accounting fees, trustee fees etc.
• Marketing expenses: These include promoting the schemes through investor awareness and education programs and the distribution commission for regular plans. The distribution commission is nil for direct plans, so the marketing expenses, as a whole, are lower for them.

How is the Total Expense Ratio calculated?

The expense ratio is calculated by dividing a mutual fund's total expenses by its total assets. The resulting percentage value is the total expense ratio of the scheme.

Formula of Expense Ratio

The formula for calculating the expense ratio of a mutual fund is:

Total Expense Ratio = (Total Expenses of the Scheme / Total Fund Assets) * 100

Let's say that a mutual fund scheme has total expenses of ₹40 lakh and manages total assets (investments) worth ₹50 crore. The expense ratio for this mutual fund scheme would be:

(40 lakh / 50 crore) * 100 = 0.8%

Impact of TER on Mutual Fund Returns

Simply put, TER is the cost of investing in mutual funds. 

All investors would want the cost of investing to be low because a lower TER will result in a higher net return, whereas a higher TER will result in a lower net return. Even slightly lower TERs can boost your returns significantly over the long term.

Suppose you invest ₹10,000 lakh each in 2 mutual fund schemes, MF-A and MF-B, with identical annual expected gross returns of 10%. Assuming TERs of MF-A is 1.5% and MF-B is 2.00% over 10 years, your portfolio values and net returns will be as follows:

As you can see, over a 10-year period, a 0.5% higher TER on a ₹10,000 investment results in around ₹1,000 lower portfolio value.

The difference will be significantly higher over higher investment periods because the expense ratio difference compounds over time. Further, the absolute difference will be higher for larger investments.

Expense Ratio: Direct vs Regular Plans

On Jan 1, 2013, SEBI introduced various mutual fund reforms in India. Among them, SEBI mandated AMCs to offer ‘direct plans’ of each scheme which will have nil distribution charges paid to mutual fund distributors/agents.

The intention was to empower sophisticated investors to invest in mutual funds through their own research and without the assistance of a mutual fund distributor/agent. It rightly reduces the cost of investing for them as they don’t avail the assistance of a mutual fund distributor/agent.

However, it is important to note that ‘direct plans’ are not everyone’s cup of tea. The easy availability of apps that let you invest in direct plans resulted in more investors choosing to invest in them. But behaviourally, it has not worked out well.

First, investors, especially new investors, lack the temperament to deal with the volatility of the stock market. With no investment experts to rely on, such investors exit from their mutual funds at the first sign of volatility.

Even AMFI data as of 2023 suggests this: 26% of regular SIP AUM (guided by mutual fund distributors) has been active for 5+ years against 14% of direct SIP AUM.

This can be attributed to the hand-holding and investment expertise that is available at all times, from mutual fund distributors to regular plan investors.

Everything said a lower expense ratio is more beneficial to you but with the caveats discussed above.

Are Total Expense Ratios Comparable?

Yes, you can compare total expense ratios. However, comparing TERs of any two mutual fund schemes would not be right. If you are comparing TERs to figure out if a scheme is affordable, you need to ensure that all the following conditions are satisfied:

• Identical category of schemes: The category of the mutual fund schemes in consideration must be identical. You cannot compare an equity fund's TER with a debt fund's TER. Further, the comparison would make more sense if the subcategory (examples - large-cap fund, liquid fund) are identical too. 
• Identical plan: Comparing the TER of a scheme’s regular plan with the TER of another scheme’s direct plan would not make sense as we saw the direct plan TERs are lower by design.
• Similar AUM (Assets under management): As we will see, SEBI has capped the max TER of mutual fund schemes based on their AUM. So, the TERs charged by large equity schemes will almost always be less than those of smaller equity schemes. If the AUMs are not too far apart, TERs may be comparable.

Note: Comparing TERs of two mutual fund schemes may not be conclusive because both funds may have a very high TER compared to other funds in their category/subcategory. To gauge the affordability of a mutual fund scheme precisely, you should compare its TER with the average TER of the subcategory.

Total expense ratio cannot be the make or break factor to select or disregard a mutual fund scheme.

Instead, you should consider other factors, such as the fund manager's track record, investment strategy, and portfolio composition, to make an investment decision.

TER Limits

SEBI (Mutual Funds) Regulations, 1996 has defined maximum permissible TER limits for mutual fund schemes to protect the interests of the investors.

Where to Find the Total Expense Ratio of a Scheme

Investors can find the total expense ratio of any mutual fund scheme on:

Mutual fund company's website: The expense ratio information is usually available in the fund's fact sheet, accessible on the mutual fund company's website. The TER is daily updated on the AMC’s digital interfaces (like mobile app).

AMFI (Association of Mutual Funds in India) website: As per the current SEBI Regulations, mutual funds are required to disclose the TER of all schemes on a daily basis on their websites as well as AMFI’s website.

Financial websites: Several financial websites provide information on mutual funds, including expense ratios.

Further, you can find the breakdown of the total expense ratio across management fee, RTA fee, GST etc. on the mutual fund company’s website for all its schemes.

Conclusion

The total expense ratio is an important factor to consider when selecting/investing in mutual funds, as lower TER can potentially result in higher returns.

However, TER should not be the ultimate factor when selecting/investing in mutual funds. Your primary motive should be to create wealth and achieve financial goals, not invest in mutual funds with the lowest expense ratio. So prioritise the former even if you have to compromise on the latter.

Total Expense Ratio FAQs

What is the ‘base total expense ratio’ and is it different from ‘total expense ratio’?

Base TER excludes additional expenses provided in Regulations 52(6A)(b) and 52(6A)(c) of SEBI (Mutual Funds) Regulations, 1996 and GST on Investment and Advisory fees. Hence, base TER is a smaller component of the TER.

What is a good expense ratio?

There’s nothing like a good expense ratio. From an investor perspective, a low expense ratio can be considered good as it saves costs. Further, expense ratio should be just one of the factors when choosing a mutual fund scheme and not the only factor.

How often does the expense ratio change?

Mutual Funds or AMCs can change the expense ratio as often as they want. However, any change in expense ratio needs to be communicated to the investors.

Does the expense ratio include the agent commission?

The expense ratio of regular plans of mutual fund schemes includes the commission or brokerage that is paid to the mutual fund distributor or agent. In case of direct plans, the agent commission is nil.

Which mutual funds have the lowest expense ratio?

Index funds and Exchange Traded Funds(ETFs) have the lowest expense ratios. These funds aim to replicate the performance of an index/benchmark and don’t require active fund management which results in super low expense ratios.