Decoding TER for your benefit!

There has been a heated debate on fund expenses in India lately, with SEBI also upping disclosures on this front. Here are answers to some oft-asked questions from investors.

What types of costs should I expect to incur while investing in a mutual fund?
A majority of investors in India buy their mutual funds from AMCs (asset-management companies) and not through the stock-exchange platform. So, when you buy any scheme from an AMC, you may incur two kinds of costs: an annual recurring charge, which is called the total expense ratio (TER), and an exit load. Some schemes charge you an exit load if you sell your units within a specified period. When you buy funds through the stock exchange (as you do with exchange-traded funds for example), you also incur brokerage charges on your purchase or sale value in addition to the scheme's TER.

So should I reduce the TER from the NAV before comparing fund returns?
No. The NAV returns of Indian mutual funds already factor in the impact of the costs. This is because the NAV of a scheme is calculated by deducting the TER from the value of the scheme's portfolio.

What about the commission to my agent or distributor?
That is included in your scheme's TER. Indian funds are not allowed to charge investors any separate load towards distributor commissions. The AMC is supposed to pay its distributors or agents from the annul TER itself. However, lately, SEBI has been encouraging distributors to register as full service advisors and to charge a fee to their investors for the advice rendered. If you use the services of such registered investment advisors, or RIAs, you may pay an added advisory fee, apart from the TER.

Who pays the fund manager who manages my scheme?
The investment management fee is also included in the TER of the fund.

Can AMCs charge anything and everything under TER?
No. SEBI regulations give a list of 12 very specific recurring items that can be charged under TER of any scheme. The most important of these are marketing and selling expenses, agents' commissions, registrar fees, audit fees, trustees fees, costs of investor servicing, statutory advertisement costs, apart from the investment management fee.

How do the TERs of direct plans differ from those of regular plans?
The TERs of direct plans are usually lower by at least 20 to 30 basis points as compared to those of regular plans because funds are not allowed to charge the distributor-commission component to direct plans. Direct plans are open only to investors who do not use the services of distributors or agents to transact in mutual funds. But do note that direct plans do charge all costs except distributor commissions.

What is this slab structure I am hearing so much about?
SEBI has a slab based system that specifies the maximum TER that any scheme can charge on a recurring basis.

Under this system, for the first Rs100 crore of assets, a scheme can charge 2.5 per cent per annum. For the next Rs 300 crore, it can charge 2.25 per cent. For the next Rs 300 crore, the TER reduces to 2 per cent. On any assets that exceed Rs 700 crore, the TER is capped at 1.75 per cent. In effect, therefore, the smallest schemes (sub-Rs 00 crore) get to charge the highest expenses every year, and as the fund size grows, the costs fall.

For debt schemes, the TER is 0.25 per cent lower across all slabs. The TER here is calculated on the daily net assets.

If SEBI caps scheme expenses at a maximum of 2.50 per cent, how come I see schemes on the Value Research website with much higher TERs such as 3 per cent or even 3.31 per cent?
The 2.50 per cent cap for equity schemes and 2.25 per cent for debt schemes are the base TERs allowed to be charged. SEBI rules allow schemes to add a few extra items of expense to their base TER:

1. An extra 0.30 per cent if the scheme gets 30 per cent of its gross inflows, or 15 per cent of its net assets, from the 30 cities beyond the top 15 (called B30) cities. Earlier this was applicable on B15 cities but was changed to B30 in February.

2. An extra 0.05 per cent in lieu of exit loads that are credited to the scheme (this has been reduced from 0.20 per cent in March)

3. GST on the management fee incurred by the scheme

As these are over and the above the slab-based limits, some schemes feature higher expense ratios.

What happens if an AMC ends up spending far more than what the slab structure allows in a particular year?
Then the costs cannot be charged to the scheme. The spill over costs must be borne by the AMC or the trustee or the sponsor of the fund.

Isn't 2.5 per cent too much to pay for passive funds?
Only active funds are allowed the above expense ratios. In the case of passive funds, SEBI caps the TER at 1 per cent for index funds bought from the AMC and at 1.5 per cent for ETFs or exchange-traded funds. This is irrespective of their sizes.

So will I be paying these expenses twice on fund of funds schemes?
No. While a fund of funds may carry two sets of expenses - one for the fund and the other for its underlying investments, SEBI regulations say that the total expenses of a fund of funds cannot exceed 2.5 per cent of its daily net assets. So even if a fund of funds charges an expense ratio and all the underlying schemes charge it, your total expenses cannot exceed 2.5 per cent of your NAV.

Are expense ratios for Indian mutual funds far higher than those in developed markets like the US?
Yes, they are. According to the Investment Company Institute, active equity funds in the US charged an annual TER of 0.63 per cent and bond funds charged 0.51 per cent in 2016. But then, you should be aware that while TERs in India include all the costs incurred in the investment, in other markets such as the US, investors may pay out other costs in addition to the TER.

In India, the regulator has banned entry loads (upfront charges) while buying a mutual fund. However, funds in other markets do charge upfront loads of about 1 per cent. Also in India, the commissions paid to mutual fund distributors are included in the TER and very few investors shell out any additional fee to the distributor or advisor because the fee-based advisory model hasn't yet taken off. In developed markets though, the advisory fee is generally paid by investors out of their pocket.

Globally, investors are migrating towards lower-cost funds. So, should I look at TER or fund returns while schemes?
Your primary objective in investing in a mutual fund is wealth creation. Therefore, a fund's track record should be your first criterion in selecting a scheme. When you assess a fund's track record, those returns are already net of expenses. Therefore, comparing those returns to the category or the benchmark will tell you what the fund manager has delivered to investors after accounting for all expenses.

However, the TER is certainly one of the factors you should consider while choosing between schemes because the TER decides the excess returns or alpha that the fund manager will deliver over the benchmark or category. For example, if a fund which gains 4 percentage points more on its portfolio than the index in a particular year has a TER of 3 per cent, the alpha it will deliver to the investor is 1 percent. A fund which gains 3 percentage points but has a lower TER of 1.5 per cent can deliver a higher alpha of 1.5 percent. Therefore, if you are undecided between two funds with a very similar track record, the one with the lower TER should be your choice.

TER comparisons are more important for mutual fund categories where the alpha-generation potential is limited. In debt funds, arbitrage funds or hybrid debt-oriented funds, the TER can significantly dent the returns earned by the investor. Therefore, do check out a scheme's TER and compare it with the TERs of the peers before selecting a fund in these categories.

Where do I get data on TERs?
You can get data on the TER from the website of the respective mutual fund, from its monthly factsheet and from www.valueresearchonline.com.

From where you source the data would depend on the purpose for which you are compiling it. If you have already decided on your choice of scheme or are holding a scheme, the AMC's own website may be the best place to keep updated on TERs. With effect from March 1, SEBI has required all mutual funds to disclose the daily TERs for all their schemes on their websites in a downloadable format. This disclosure also gives you a breakup between the base TER and the additional charges. When there's a change in the TER, the AMC is required to disclose this three days in advance.

If you are looking to compare TERs within a category, the Fund Category Returns tables on www.valueresearchonline.com are a good resource that offers a single-page view of all scheme TERs in a category. You can also sort schemes by both returns and TER to make your choice.