What is Expense Ratio?

The Total Expense Ratio (TER) is the annual fee charged by Asset Management Companies (AMCs) to cover the costs of managing and operating a mutual fund scheme. It represents the percentage of a fund's assets that goes toward operational expenses and is deducted from the fund's Net Asset Value (NAV) on a daily basis.

Formula and Calculation

Expense Ratio = (Total Annual Expenses / Average Assets Under Management) × 100

Example Calculation:

If a fund has:

• Total annual expenses: Rs. 2 crores
• Average AUM: Rs. 500 crores
• TER = (Rs. 2 crore / Rs. 500 crore) × 100 = 0.40%

This means for every Rs. 100 invested, Rs. 0.40 goes toward fund management annually.

If these expenses go up or go down, AMCs usually increase/reduce the total expense ratio from time to time.

Components of Expense Ratio

1. Management Fees

• Core fee paid to fund managers for investment decisions
• Portfolio management and research costs
• Typically the largest component of TER

2. Administrative Expenses

• Registrar and transfer agent fees
• Custodian charges
• Legal and audit fees

3. Transaction Costs

• Brokerage charges for buying/selling securities
• Market impact costs

4. Other Operating Expenses

• Regulatory compliance costs
• Office expenses and utilities
• Technology and infrastructure costs

5. Distribution Expenses (for Regular Plans)

• Commissions paid to distributors and agents
• Marketing and advertising costs
• Only applicable to Regular Plans (Direct Plans exclude these)

How Expense Ratio is deducted?

Daily Deduction Process:

• TER is calculated and deducted daily from the fund's NAV
• The annual percentage is divided by 365 days
• Daily deduction = (Annual TER / 365) × Daily NAV

Example of Daily Deduction:

For a Rs. 1 lakh investment with 1% TER:

• Daily deduction = (1% / 365) × Rs. 1,01,000 = Rs. 2.76 per day

Impact on NAV:

• The published NAV is always net of expenses
• Investors see the NAV after TER deduction
• No separate bill is sent to investors

SEBI Regulations and Limits

Current TER Limits (Effective April 1, 2020):

Assets Under Management (AUM in Rs.)	Equity Funds TER	Debt Funds TER
First Rs. 500 Cr	2.25%	2.00%
Next Rs. 250 Cr	2.00%	1.75%
Next Rs. 1,250 Cr	1.75%	1.50%
Next Rs. 3,000 Cr	1.60%	1.35%
Next Rs. 5,000 Cr	1.50%	1.25%
Next Rs. 40,000 Cr	0.05% reduction for every Rs. 5,000 crore increase
> Rs. 50,000 Cr	1.05%	0.80%

*Assets Under Management (AUM) in short is the total market value of all the investments that a financial institution, such as a mutual fund or an investment firm, manages on behalf of its clients.

Think of it as the total size of the investment pool being managed.

Additional Allowances:

• Extra 30 basis points if new inflows from B30 cities (beyond top 30 cities) meet specified criteria
• Extra 5 basis points from exit load credits
• GST on management fees charged over and above TER limits

Special Categories:

Fund Type	TER Limit
Index Funds/ETFs	1.00%
Closed-ended Equity Schemes	1.25%
Fund of Funds (Equity)	2.25%
Fund of Funds (Debt)	2.00%

Historical Evolution

Pre-2018 Era:

• Higher TER limits with less granular slabs
• Limited transparency in expense allocation
• Concerns about high costs for retail investors

2018 Reforms:

• Introduction of more granular AUM slabs
• Reduction in TER limits for larger funds
• Enhanced disclosure requirements

2020 Revision:

• Current slab structure implemented
• Further reduction in TER for large funds
• Incentives for B30 city penetration

2023 Consultation:

• SEBI proposed further reforms for transparency
• Focus on economies of scale for retail investors
• Measures to prevent churning and mis-selling

Importance and Impact

Long-term Impact Example:

Consider two funds with identical 10% returns:

• Fund A: 0.5% TER → Net return: 9.5%
• Fund B: 1% TER → Net return: 9%

Over 20 years on Rs. 1 lakh investment:

• Fund A: Rs. 6.14 lakhs
• Fund B: Rs. 5.60 lakhs
• Difference: Rs. 0.54 lakhs due to TER difference alone

Active vs Passive Funds:

• Active Funds: Higher TER (1.0-2.25%) due to research and active management
• Passive Funds: Lower TER (0.1-1.0%) due to minimal portfolio changes

Direct vs Regular Plans:

• Direct Plans: Lower TER (no distribution expenses)
• Regular Plans: Higher TER (includes distributor commissions)
• Typical Difference: 0.5-1.0% annually

What constitutes a good Expense Ratio?

Benchmarks:

• Actively Managed Equity: 0.5-1.5% considered reasonable
• Actively Managed Debt: 0.5-1.25% considered reasonable
• Index Funds: 0.1-0.5% considered good
• ETFs: 0.05-0.25% considered excellent

Evaluation Criteria:

1. Compare within the same category
2. Consider fund performance net of expenses
3. Factor in fund size and economies of scale
4. Assess value-added services and research quality

Recent developments and Trends

Industry Trends:

• Decreasing TERs: Due to scale economies and competition
• Greater Transparency: Enhanced disclosure norms
• Technology Impact: Lower operational costs
• Regulatory Push: Toward lower costs for retail investors

Future Outlook:

• Further TER Reductions: Expected for large funds
• Enhanced Transparency: More granular cost disclosure
• Innovation Incentives: Balanced with cost considerations
• Retail Focus: Continued emphasis on affordable investing

Key Takeaways for Investors

1. Daily Impact: TER affects returns daily, not annually
2. Compounding Effect: Small TER differences create large long-term impact
3. Category Comparison: Compare TER within similar fund categories along with performance of the funds
4. Performance Balance: Consider performance net of expenses, NAV includes TER. so growth in NAV covers the TER as well, so no need to deduct TER separately.
5. Direct Advantage: Direct plans offer significant TER savings,  regular mutual fund plans offer personalized investment advice, Regular plans without any Financial advice might cost you a lot in the long run.
6. Scale Benefits: Larger funds often have lower effective TERs, Newly launched funds might also have lower TER but without any track record, choose the plans wisely.

The expense ratio remains a critical factor in mutual fund selection, directly impacting long-term wealth creation. Understanding its components, calculation, and regulatory framework helps investors make informed decisions and optimize their investment returns.

Regards,

Honvest Team