Making sense of MF expenses

Should you act on the daily mails on Total Expense Ratios from different fund houses?

If you are a mutual-fund investor, you’re probably being deluged by daily mails on Total Expense Ratios from different fund houses. In February, SEBI had asked all fund houses to intimate their investors before making changes to their TER. It also asked them to maintain an updated daily spreadsheet of their scheme-wise TERs on their websites. So should you act on these disclosures? Only rarely.

TER basics

In India, SEBI requires MFs to pack all the costs they charge to investors, into TER — be it management fees, transaction costs, marketing costs or distributor commissions. It lays down a slab structure that caps the base TER at anywhere between 1.5 and 2.5 per cent of a scheme’s average assets. Apart from this, they can charge a few extras — up to 0.30 per cent for inflows from smaller cities and towns, and a GST component. These add on to the base TER to make up a scheme’s total TER. Therefore, TER represents all the costs that are charged to your scheme before its portfolio returns can reach you.

SEBI is concerned about TER changes because even a 50-basis point change in TER can make a significant difference to what you finally take home from a mutual fund. An equity fund with 1.5 per cent TER and 15 per cent portfolio return, can convert your ₹1-lakh investment into ₹6.68 lakh at the end of 15 years. But if it bumps up that TER to 2 per cent, your final proceeds will fall to ₹6.25 lakh.

But it is important not to overreact to the frequent TER disclosures.

Go by category

Whether a TER change is material to your returns will depend on the scheme category you’ve invested in and its return potential.

In the equity or hybrid return categories, changes of 0.50 percentage points or more in TER may be something to worry about. With their annual returns at 12-15 per cent, smaller TER increases may not make a material dent in their returns. But in the case of arbitrage funds or liquid funds, even a 0.25 percentage point spike in TER can mean a body blow to returns.

A good way to evaluate if a TER change is material to your scheme is to look at TER as a proportion of the scheme’s returns, rather than as a proportion of its assets.

So, a 0.25 percentage point increase in an arbitrage fund’s TER will trim its returns from 6.50 to 6.25 per cent, but an equity fund’s returns would just blip from 15 to 14.75 per cent.

Also, TERs are far more important for index funds — given the minimal scope for serious value-add — than for active equity funds, and for liquid funds than for credit funds.

It’s a relative call

When it comes to TER, relative numbers matter more than the absolute. A fund’s TER e-mail may inform you that it has sharply hiked its TER. But to know whether this rise is unreasonable, you will need to stack up its TER against peers in its category. At times, schemes that have set their TERs too low relative to peers may correct them for size or popularity.

Peer comparison will help put expenses in perspective.

Direct or regular

A key benefit of the new TER mailers is that they allow you to compare the total TERs of direct and regular plans that were earlier well-hidden.

So, if a scheme charges 3 per cent TER on its regular plan and 2.25 per cent on its direct plan, 0.75 per cent is the extra cost you are bearing towards the services rendered by your distributor or advisor. But be sure to make the choice between direct and regular plans based on not just cost savings, but also your knowledge and ability to devote time and effort to managing your MF portfolio.

Finally, a scheme’s TER is already baked into its NAV. If your fund is consistently beating its peers and benchmarks by a convincing margin, the fund manager is likely delivering sufficient value-addition to justify the TER, even if high.

If it is lagging, it may not be worth hanging on to, even if its TER is the biggest bargain in its category.

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