Total Expense Ratio (TER): Meaning and Importance
To run a business, the owner should incur operating costs. In the same way, Asset Management Companies (AMCs), that own and administer mutual fund schemes, also need to pay operating costs to make sure that the funds are managed well by the fund managers.
The operating cost consists of the following:
- Management fee: This is paid to the fund managers who are responsible to invest the fund’s assets in specific equity/ debt securities to achieve the fund objectives.
- Research & Development to make sure that your fund is made up of the best securities.
- Register Transfer Agents (RTAs) Fee: They are responsible to maintain a record of investors’ personal data, which includes buying/switching/redeeming of fund units.
- Legal & Marketing expenses
- Distribution commissions, that a fund house pays to the mutual fund distributor
In the case of Direct funds, you directly invest with the AMC and no bank or distributor is involved. Hence, these funds don’t charge you the distributor commission and have a lower expense ratio.
However, in the case of Regular funds, you invest in mutual funds with the help of a bank/distributor. Thus, these funds charge you a distributor commission and have a higher expense ratio.
How do you calculate the Expense Ratio of a fund?
The expense ratio is arrived at by dividing the total expenses incurred by a mutual fund house by its assets under management.
(Total Expenses incurred by the fund house)/ (Total Assets Under Management)
However, SEBI (Securities & Exchange Board of India) has laid out limits that the fund houses have to follow with regard to expense ratio. For example, equity-oriented schemes with an AUM of less than 500 crores, cannot charge you expense ratio more than 2.25%.
How does the Expense Ratio affect your fund returns?
The Net Asset Value (NAV) of the fund reflects the returns earned by a mutual fund scheme. Whenever you invest in a mutual fund, you buy units of the fund at this NAV. You should know that the NAV of the fund is calculated after deducting the expenses incurred by the fund house.
Hence, a higher expense ratio puts downward pressure on the fund NAV and creates a higher charge on it. The end result of this is relatively lower returns in your kitty.
Let us understand this with an example:
Suppose you invested Rs. 20,000 in a mutual fund scheme that has an expense ratio of 2%. It means that the fund house would deduct a charge of Rs. 400 annually from the returns to manage your investments.
Depending on the changing value of your investment, this expense ratio is charged until the time you are invested in the fund.
So, if the scheme earns 15% returns after 1 year and you want to redeem your investment, then your returns should be equal to Rs. 3,000 (i.e. 15% x 20,000). However, with an expense ratio of 2%, your returns on investments will be equal to 13%, i.e. Rs. 2,600.
What is your return on investment in Regular funds?
As time passes by, compounding and commissions can bring about a tremendous difference in the amount of returns that your fund generates.
Let’s have a look at how expense ratios of direct and regular plans vary across different sub-categories of equity mutual funds here.
You will find that in every category your returns from the direct funds are up to 1% higher or even more. This difference of 1% is the commission that would have otherwise been paid to your distributor had you invested in a regular plan.
How does Paytm Money help you save on commissions?
Investing in direct funds, instead of regular funds, can help you to save on distributor commissions. You can invest in your preferred direct fund on Paytm Money to get the best from your investments. This helps you to earn up to 1% higher return than the regular plan of mutual fund schemes.
In the beginning, this difference of 1% may seem trivial. However, it can grow to become a massive amount over a long period of time, thanks to compounding.
Direct funds are ideal for investors who know which funds to invest in. If you are not sure about which is the right fund for you, then you can explore our Paytm Money Investment Packs. These packs consist of assorted schemes of only direct plans that suit your risk profile.