TERs and returns of MFs

Since the last couple of months, mutual fund investors have been receiving letters and emails from fund houses informing them about the change in total expense ratio (TER) of the scheme they have invested in. If you are one among them, you might have wondered what you should make of it. Should you be worrying about the hike in the expense ratio of your mutual fund scheme or should you just ignore it? Well, if your investments in mutual fund schemes run into millions of rupees, then you should definitely have a look at the expense ratio because, in the long term, any increase or decrease in the TER will make quite a big impact on the returns of the schemes you have invested in.

Of course, the Securities and Exchange Board of India (SEBI) has put an upper limit on the TER that can be charged by the fund houses. In the case of an equity scheme, the maximum TER that can be charged is 2.5% of the AUM, while in the case of a debt scheme, the maximum TER the fund house can charge is 2.25% of the AUM. Therefore, the fund house is free to charge any expense ratio it deems fit below the specified ceiling.

The expenses of a fund house comprise of management fees, administration costs and distribution costs. Since these expenses are deducted from the corpus of the fund, the fund corpus will decline to that extent, which directly impacts the returns to the investors who have invested in the scheme. Hence, if the TER is increased by the fund house, it will have a negative impact on returns, whereas if the TER is decreased, it will have a positive impact on the returns.

The TER for regular and direct plans differ since there are no distribution expenses involved in the direct plan as the investor buys the units directly from the fund house and also sells them directly to the fund house. In the case of regular plan, the investors buy from the broker or distributor, so the cost of distribution is deducted from the premium paid by the investor. This reduces the returns of the investor investing in a regular plan.