Decoding total expense ratio

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Context:

  • Securities and Exchange Board of India (SEBI) announced changes to total expense ratio (TER) of mutual funds. Srikanth Meenakshi, founder and chief operating officer, FundsIndia.com explains about the metric. Edited excerpts:

What is total expense ratio and why is it important for investing in mutual funds?

  • Mutual funds are investments where an investor entrusts his/her money with an investment manager (of an asset management company) to manage the money smartly and efficiently. This money management comes at a cost, which is usually charged as a percentage of the investment. The official regulator of mutual funds has laid down rules on how much an asset management company can charge an investor to manage their funds. For an investor this is important because it is a charge (called total expense ratio or TER in short) levied on their investment, and the money they get back from their investment is reduced by this figure. For example, if a fund charges 2% as the TER, and the fund produces a gross profit (return) of 15% in a given year, the investor would get 13% – which is the gross profit minus the TER – in their hands.
  • So, for an investor, TER is an important number to focus on since it has a direct impact on their returns. However, it is not the only number to look at and investors should evaluate funds based on various parameters such as consistency of performance and risk levels.

What are the changes made by SEBI now to TER?

  • SEBI has, across the board, lowered the TER that a fund house can charge its investors. The reduction is higher for larger funds and lower for smaller funds — larger and smaller being a measure of how much money a fund manages. The reduction has been anywhere between 0.01% to 0.44%. For very small funds, SEBI has actually increased the allowable expense ratio a little. However, in general, mutual fund investors should see a marginal reduction in the fee they were paying, which would mean they would see an increase in the returns they were getting. Also, SEBI has specified the expense ratio for funds larger than the largest funds today, in anticipation of market growth.

Post the changes, as a retail investors will benefit?

  • Let’s take an example to understand. A very popular fund among investors is a hybrid fund called HDFC hybrid equity fund. This fund manages assets worth close to ₹24,000 crore. The base TER (the TER prior to GST and some minor additional expenses) that this fund is charging now is 1.76%. Post the recent change, they will be able to charge as base TER would be 1.50%, a reduction of 0.26%.
  • So if an investor is investing ₹1 lakh in this fund, and the fund realises a gross profit of ₹20,000 in a year (20% profits), the investor would get in hand (when he redeems), an amount, roughly, of ₹117,888. After the new rules are in place, the same investor would stand to get an amount roughly of ₹118,200 – a gain of ₹312 from previously.

How the changes will affect mutual fund houses?

  • For mutual fund companies, there will definitely be a loss of revenue, as there will be for other participants in the industry, such as individual financial advisors and distributors. The magnitude of the impact will be known only after we find out how the AMCs deal with the situation – in terms of, how much of the reduction they are passing on to the distributors and how much they are taking on in their own balance sheets.