What are Mutual Funds? What is the Total Expense Ratio (TER)?
What are Mutual Funds?
- A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets.
- Mutual funds are operated by professional money managers, who allocate the fund’s investments and attempt to produce capital gains and/or income for the fund’s investors.
- Mutual Funds are regulated by SEBI.
What is the Total Expense Ratio (TER)?
- The total expense ratio (TER) is a measure of the total costs associated with managing and operating an investment fund, such as a mutual fund.
- These costs consist primarily of management fees and additional expenses, such as trading fees, legal fees, auditor fees and other operational expenses.
- For example, if a fund charges 2% as the TER, and the fund produces a gross profit (return) of 15% in a given year, the investor would get 13% – which is the gross profit minus the TER – in their hands.
- Therefore, TER is an important number to focus on since it has a direct impact on their returns.
- It is calculated by dividing the total annual cost by the fund’s average assets over that year, and is expressed as a percentage.
What is an ‘Assets Under Management – AUM’?
- Assets under management (AUM) is the total market value of assets that an investment company or financial institution manages on behalf of investors.
- Assets under management definitions and formulas vary by company.
- Some financial institutions include bank deposits, mutual funds and cash in their calculations. Others limit it to funds under discretionary management, where the investor assigns responsibility to the company.
What was the issue?
- It has been argued that while the MF industry has benefited in terms of growth in revenues from the rise in AUM, the benefits had not been passed on adequately to investors, even as their expenditure on managing the fund rose marginally.
Solution- TER Rationalisation
- The Sebi Board took note of the benefits of the proposal with respect to sharing of economies of scale, lowering the cost for mutual fund investors, bringing in transparency in appropriation of expenses, and reducing mis-selling and churning.
What are the changes made by SEBI now to TER?
- SEBI has, across the board, lowered the TER that a fund house can charge its investors.
- The reduction is higher for larger funds and lower for smaller funds — larger and smaller being a measure of how much money a fund manages.
- The reduction has been anywhere between 0.01% to 0.44%.
- For very small funds, SEBI has actually increased the allowable expense ratio a little.
- However, in general, mutual fund investors should see a marginal reduction in the fee they were paying, which would mean they would see an increase in the returns they were getting.
- Also, SEBI has specified the expense ratio for funds larger than the largest funds today, in anticipation of market growth.
How investor will benefit?
- Investors can save up to 80-90 basis points in charges, every year, on their AUM.
- For example, the SBI Bluechip Fund (AUM over Rs 20,000 crore) has a TER of 2.35%.
- Under the new rules, the TER will come down to 1.4% (plus the additional TER on account of inflows from B-15 cities), and thus the investor will save between 80 and 90 basis points.
- An investment of Rs 1 lakh in the scheme, growing at, say, 10% for 20 years with a TER of 2.35%, would have grown to a corpus of Rs 4.18 lakh; the same investment with a TER of 1.5% would grow into a corpus of Rs 4.99 lakh.
How the changes will affect mutual fund houses?
- For mutual fund companies, there will definitely be a loss of revenue, as there will be for other participants in the industry, such as individual financial advisors and distributors.
- The magnitude of the impact will be known only after we find out how the AMCs deal with the situation – in terms of, how much of the reduction they are passing on to the distributors and how much they are taking on in their own balance sheets.