What Is TER In Mutual Fund – Meaning, Limitations & How To Calculate

When you invest in a mutual fund, it’s essential to know not only the returns but also the costs involved. Among the various costs an investor faces, one of the most significant is the Total Expense Ratio or TER. The TER represents the annual cost of managing and operating a mutual fund as a percentage of its average assets under management (AUM). This article delves into what the Total Expense Ratio is, how it works, how to calculate it, and its impact on the performance of your investments. 

Understanding TER is key to making informed decisions about which mutual fund to invest in.

What is the Total Expense Ratio (TER)?

The Total Expense Ratio, also known as the TER, is a formula that is used to define the total cost of handling a mutual fund. It demonstrates the proportion of the assets of the fund that is considered for its operating expenses, be it the management fees, administrative fees, or marketing fees, among other associated costs. As such, the TER represents the annual percentage of an average amount of assets controlled by the fund.

For investors, the TER in mutual funds is a crucial factor in evaluating the cost-effectiveness of a mutual fund. The TER is deducted directly from the fund’s assets, meaning it reduces the fund’s returns over time. Thus, a higher TER translates to higher costs, which can erode the overall performance of your investment.

How Does Total Expense Ratio (TER) Work?

The TER is calculated by summing up the operational expenses for running a mutual fund in a single percentage figure. Such costs are taken out of the fund’s assets, meaning less money is available for distribution to investors. Although the TER captures the ongoing annual fee, it excludes the transaction costs that come with the buying or selling of securities in the fund or the capital gains taxes.

For instance, suppose a fund has an annual TER of 2% and returns 8% gross. In that case, the investor would realize a net return of 6% after deducting the TER. With time, TER can add up significantly, particularly for long-term investors. High TER can, therefore, significantly deduct from the overall returns that investors earn year in and year out.

A fund’s TER is typically disclosed in a fund’s KIM and fact sheets. It is always prudent for an investor to compare the funds using this figure. A high TER might mean the fund’s management is expensive, whereas a low TER might mean cost-effective operations. However, the TER is not an adequate determinant for making investment decisions; it must be combined with other factors, such as the fund’s performance, investment strategy, and risk profile.

Total Expense Ratio (TER) Formula

The formula to compute the Total Expense Ratio in mutual funds is quite simple:

Total Expense Ratio (TER) = Average Assets Under Management (AUM)/Total Fund Expenses​×100

Where,

1. Total Expenses: The total operations costs the fund makes during a particular year. It includes administration fees, management fees, custodian fees, marketing, and other professional fees incurred during fund management.
2. Average Assets Under Management (AUM): The average value of the assets managed by the mutual fund during the year. This is usually calculated by averaging the assets under management at different points during the year.

TER Calculation

Let’s go through a practical example to better understand the TER calculation.

Assume a mutual fund reports the following for the year:

Total Expenses: ₹5,00,000 (this includes management fees, administrative expenses, etc.)

Average AUM: ₹30 crore

The TER can be calculated as follows:

TER = 5,00,000/30,00,00,000 ×100=0.16%

This means the mutual fund charges an annual fee of 0.16% of its assets to cover all expenses.

If you invested ₹1,00,000 in this fund, you would pay ₹167 as your share of the fund’s operating costs over the year. While TER is a useful tool for gauging the cost-efficiency of a fund, it’s also essential to evaluate the fund’s historical performance, risk profile, and investment objectives before making any decisions.

Major Costs That Add Up to TER in Mutual Funds

The TER comprises a wide array of expenses related to running and managing the mutual fund. Here are the key components that form the TER:

1. Management Fees: This is the primary component of TER, which represents the fee paid to the fund manager or the investment advisory firm for managing the portfolio. It usually works out as a percentage of the assets under management and may vary between 0.5% and 2% per annum, depending on the kind of fund and the expertise required.
2. Administrative Fees: These expenses include costs related to record-keeping, compliance, reporting, and accounting. While relatively smaller than management fees, administrative costs are essential for ensuring the smooth operation of the fund.
3. Custodian Fees: Mutual funds are always supposed to keep their securities with a custodian bank to ensure safekeeping as well as proper settlement. This custodian charges according to the size of the assets they hold. All this is added to the total TER.
4. Other Operational Costs: These can include audit fees, legal costs, and regulatory compliance expenses. Funds also incur costs related to investor communication, such as sending statements and disclosures.

This will enable the investor to gauge the entire cost of investing in a fund. A fund may be more expensive because of high management or marketing fees, while a fund with low administrative fees could provide more favorable cost structures.

SEBI Limit on TER in Mutual Funds

In India, the SEBI has laid down guidelines for mutual funds based on the total expense ratio charged. These regulations from SEBI ensure that investors are not burdened with too many charges while also fostering a competitive environment among fund houses.

According to regulations laid down by SEBI:

• For mutual funds with assets up to ₹500 crore, TER is capped at 2.25% for equity schemes and 2% for debt schemes.
• For funds with assets between ₹500 crore and ₹1,000 crore, TER is capped at 2% for equity schemes and 1.75% for debt schemes.
• For funds with assets over ₹1,000 crore, TER is capped at 1.75% for equity schemes and 1.50% for debt schemes.

These caps function in an arena where fund houses want to remain competitive while keeping costs low for investors. Therefore, major funds with large assets under management can give economies of scale, allowing them to charge lesser fees, whereas, with smaller funds, their TERs might be a little more but are still capped by the SEBI cap.

Understanding these limits ensures that investors are not charged exorbitant fees and can make well-informed investment decisions in mutual funds.

What Are the Limitations of the Total Expense Ratio

Even though TER is a good indicator of the cost of a mutual fund, it has various limitations to be considered by an investor before deciding on any investment:

It excludes transaction costs. The TER is calculated without considering some costs of buying and selling the security, such as brokerage fees or bid-ask spreads. Such cost would therefore sum up for active management funds due to a higher rate of turnover.

Not reflecting the performance of funds: The low TER will not mean that a particular fund performs better than any other with a higher TER. Many factors determine its performance, like the expertise of the fund manager, the strategy adopted by them, and so on. Thus, investors cannot rely only on the TER while making a decision to invest in a fund.

Different TER for Different Fund Types: Actively managed funds typically have a higher TER since the research and analysis needed to make stocks and to make portfolio management are very high. Generally, passively managed index funds have lower TERs. Hence, TER comparisons will not always be meaningful across different fund types.

Conclusion

Therefore, the TER can be a very relevant factor in choosing a mutual fund because it is the cumulative fee of managing the money, and a higher TER can further eat into your investment over time. However, the cardinal rule is that the figures alone should not determine your investment decision. Other factors include the quality of fund performance, the kind of investment strategy, and the appetite for risks the mutual fund takes.

Understanding TER enables you to opt for more economical choices while ensuring that the fund’s operational cost does not harm your long-term investment goals. Thirdly, SEBI regulations ensure an element of protection for the investors, as mutual funds cannot charge exorbitant fees. Therefore, while considering mutual funds, always consider both important elements to make a balanced investment decision and achieve your financial goals.

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