Expense Ratio What Is this fee And Why Does It Matter with examples

In the previous chapter, we explored ‘Rolling Returns’, and how it provides a better assessment of the return pattern in comparison to a simple point to point return. Now, let’s delve further into other important metrics linked to mutual funds.

In this chapter, we focus on the expense ratio of a mutual fund. Though we may have mentioned it before within this module, it is now time to formally introduce the concept. We will begin our examination before proceeding further.

When considering services like Tata Sky, Netflix, Swiggy and Dunzo that you use on a regular basis, you pay for them. This is because there are realistic costs associated with them, such as fuel, labour and tech expenses for example. A Dunzo executive has to ride his bike to the store for pickup. As a result of these expenses, you’ll be paying a fee to cover and provide added income for the organisation.

Managing your investments in a Mutual Fund is another service offered by the Asset Management Company (AMC). Of course, this comes at a cost.

The fee mutual fund charges are referred to as the Total Expense Ratio (TER).

AMCs charge fees to cover their expenses, such as custodian and Trustee fees, RTAs, fund management costs, administrative needs, brokerage bills, distributor and advertising costs. Additionally they need to maintain a profitable business model.

At this juncture, we can either delve deeper into the ins and outs of TER or gain a rudimentary understanding.

As an investor in a Mutual fund, one should keep in mind that these investments are not without cost; there will be a charge associated with them. Therefore, I advise staying with the latter choice.

Many first-time investors assume that mutual fund investments are free, as no explicit payment is made to an AMC for the fund management services. In reality, an AMC never receives a direct payment.

The service fee. I.e TER is charged in an effortless and unobtrusive way, leaving you unaware of the charge.

As a mutual fund investor, all you need to know is –

•       How is the fee charged?
•       How much is the fee charged?
•       Techniques to save on TER.

For this, I’ll use a straightforward example to help answer these questions and give you a basic understanding of TER rather than its underlying mathematics.

This AMC charges a TER of 1% or Rs.1,000 per annum for each Rs.1,00,000 invested. You don’t have to pay the fee at once when making an investment nor on a periodic basis, as it is taken out of your account on a daily basis without you even noticing it.

Let me explain –

Rs.1,000/- is the charge on an annual basis. If you do the math, this works out to –

1,0000/365

=Rs.2.73/-

It’s simple: your funds are subject to an Rs.2.73/- daily deduction. But how does this happen?

Taking Rs.10/- as the initial NAV, you are eligible to receive a sum of Rs.1,00,000/- because of your investment.

= Rs.1,00,000/10

= 10,000 units.

If the fund increases by 1% the following day, its new NAV will be –

=10*(1+1%)

= 10.1

And the value of your investment is

= 10.1 * 10,000

= Rs.1,01,000/-

The AMC requests Rs.2.73/- as an administrative fee; this will be taken from the value of your investment.

Rs.1,01,000/- minus  Rs.2.73/-

= Rs.1,00,997.3/-

Or the actual NAV applicable (and declared) is –

= Rs.1,00,997.3 / 10,000

= 10.09973.

The NAV, after taking the TER into account, stands at 10.09973, noticeably less than the pre-TER figure of 10.1.

So the point to note is –

•       The NAV that is declared is after deducting the TER
•       The money is collected from you from your investments
•       Money is deducted daily

We assumed that the value of the investments would increase by 1%. Even in the event of it decreasing, fees still remain as usual.

There are numerous factors to consider when calculating TER. SEBI has set out limits for Equity and Debt funds, as well as a maximum proportion of the fund’s assets under management. Additionally, the weight of your portfolio should be taken into account. Clearly, there is a great deal of complexity involved.

Professional ‘fund accounting’ companies are available that factor in the SEBI regulations and guide AMCs in calculating their TER based on an average weighting. Knowing how much you are paying is sufficient knowledge when investing, so delving into intricate details is unnecessary.

When selecting a fund to invest in, TER should not be the only factor taken into consideration. Even if the TER is at 2%, you should still consider other characteristics of the fund before making your final decision.

If you are considering two funds of the same type, such as an overnight fund, it is wise to compare their return profiles and opt for the one with a lower TER.

Here’s an overview of the TER for the UTI Core Equity Fund.

It’s clear that the Direct plan carries a 2.11% expense rate, while the regular plan requires 2.39%.

What is the distinction between direct and regular plans, and why do they have different TERs?