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Why is expense ratio important?

Expense ratio indicates the per unit cost of managing a mutual fund. It is calculated by dividing the total expenses by the total assets under management. Expense ratio has an impact on the returns. In other words, a higher ratio has an impact on investors net profitability.

Also, the expense ratio for actively managed funds is higher. The alpha generated by the fund manager is a justification for the fee they charge. 

Following are the components of an expense ratio:

  • Management fees
  • Administrative costs
  • 12-1b Distribution fees

As per SEBI’s regulation, the total expense ratio allowed for a fund for the first INR 100 crore is 2.5%. For the next INR 300 crore is 2.25% and 2% for the next INR 300 crores. And, for the rest of the AUM, it is 1.75%.

The limit for debt funds is 2.2.5%. In addition to this, SEBI allows all funds to charge an extra 30 basis points as an incentive to penetrate in smaller towns (B15 cities). Also, these cities enjoy an additional 20 basis points as exit load charges.

What is the net expense ratio on an ETF?

The expense ratio for Exchange Traded Funds (ETFs) is capped at 1% by SEBI. Since the funds are passively managed, their expense ratio tends to be much lower than actively managed funds. ETFs track the index; hence there is no need for the fund manager to research, analyse and trade securities. Therefore the costs of managing an ETF is much lower.

While the expense ratio of ETFs is lower, there are certain unique costs. ETFs can be traded only on stock exchanges. Every time an investor does a transaction, they will have to pay a brokerage. Moreover, the investor will also incur Securities Transaction Tax (STT) and other trading costs like differences in the bid-ask spread. Therefore the net expense ratio of ETFs includes both the fund expense ratio as well as all the trading costs that the investors incur on the purchase and sale of ETFs.

While all these costs exist in actively managed funds as well, but the fund house pays them. The fund house collects the same in terms of a higher expense ratio. Hence the investors of actively managed funds are paying these costs indirectly.

What is the base total expense ratio?

Total Expense Ratio (TER) is a measure of the total cost of managing and operating a mutual fund. It considers all operational expenses involved in running the fund and gives a clear image of their impact.

The TER includes costs such as management fees, and additional fees like trading fees, auditor fees, legal and other operational expenses.

TER is the percentage of the total cost of the fund on its total assets.

TER = Total Fund Costs / Total Fund Assets

The size of the TER is important to an investor because the costs are withdrawn from the fund. Also, it has an impact on the returns. For example, if a mutual fund generates a 10% return for a year, but the TER is 6%, then the returns are greatly affected. The actual return, in this case, is roughly 4%.

For an actively managed fund, due to high transaction fees and personnel costs, the TER is higher. While for passively managed funds, the operation costs are significantly lower, resulting in lower TER.

Published on November 9, 2020