If you have ever considered who pays for mutual fund advertisements, the costs of managing your mutual fund investments, operating costs of mutual fund companies and others, it's time to know about Total Expense Ratio [TER] of mutual funds.
As a mutual fund investor, you contribute towards the running costs of managing your mutual fund company, that is the AMC or the asset management company.
For example, if you have invested in an equity mutual fund, you could be paying an annual cost of approximately 2.5% of the total value of your investments. Generally, in India, equity funds charge 2.2% to 2.4% as the expense ratio. After adding all the costs together, it is known as the total expense ratio. If the TER is approximately 2.4% per annum, it is proportionately debited each day.
Typically, it is seen that if the assets of the mutual funds are small, the expense ratio could be high. For the mutual fund to meet its costs from restricted or a small asset base, it could raise the expense ratio. Similarly, if the net assets of the mutual fund are substantial, ideally the expense percentage must be slim.
In September 2018, SEBI initiated significant alterations by bringing ending down the total expense ratio of mutual funds. It also changed the process of providing commissions to distributors.
Understanding the elements of expense ratio
Numerous charges within the expense ratio are used to run a mutual fund scheme. Mutual fund investors contribute towards the expense ratio on a day-to-day basis, and complete disclosure is revealed every six months by the AMC on the deducted fees.
There are five significant components within the expense ratio. These include:
- Management charges - This is a considerable cost and constitutes an integral portion of the TER. It is used to run the fund office, manage a mutual fund, recruit staff and more. Generally, it is a fixed cost for any mutual fund.
- Service/GST tax - Effective from July 1, 2017, service tax has been replaced by GST, and today is an integral component of the total cost of a mutual fund. The GST of a mutual fund is approximately 18% which makes it a critical cost component for all mutual funds.
- Transfer agent charge - Transfer agents are as crucial as registrars in equity investment. Typically, the mutual fund registrar takes care of unitholders’ services that include new investments, processing the changes in ownership, dividend reinvestment, managing accounts, redeeming accounts and more. Since mutual fund houses are unable to handle such a colossal activity on their own, two principal mutual funds transfer agents in India, known as KARVY and CAMS accomplish these activities.
- Brokerage and statutory charges - These two types of commissions are essential in mutual funds. These fees are applied to execute transactions in equity and debt as part of an individual's portfolio management. Besides, the mutual fund house pays commissions to distributors and brokers who promote their products to investors. In this, there is an upfront brokerage to procure new investors and a trail commission to retain clients. A direct plan can help you to save on brokerage costs and hence could be 70 to 80 basis points lower than a regular plan.
- Operating expenses - Day-to-day operations and marketing costs are also part of the TER. Fees related to advertising, brand promotion, branding, under marketing costs and hence, regardless of whether you are under a direct or regular plan, every mutual fund investor pays towards these charges.
The impact of expense ratio on fund returns
Say you have invested ₹20,000 in a mutual fund that has an expense ratio of 2%. This means you have to pay ₹400 to the fund manager, each year to manage your investment in the fund. Simply put, if the mutual fund provides you with a yield equal to 15% with a TER of 2%, your returns will be approximately 13%.
Also, the net asset value of your mutual fund is stated after taking into account all the charges and costs. Therefore, it is critical to understand the expense ratio of the mutual fund you are paying to the AMC.
The total expense ratio plays a significant impact on your returns, especially over the long-term. Seek the best TER for your mutual fund to maximise your gains and create wealth.
Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.