Before you choose a mutual fund scheme, you are expected to factor in the total expense ratio (TER) to calculate net returns. Interestingly, the larger the fund size, the lower the TER. And vice versa is also true. The smaller the fund size, the larger the TER.
And since the fund size is evaluated in terms of AUMs (assets under management), it effectively means the schemes with larger AUMs carry lower expense ratio. So, it is advantageous to invest in a scheme with massive AUMs since not only their TER is lower, but they are more liquid too.
What is a TER?
Total expense ratio (TER) refers to the total cost incurred by the fund house in meeting operational expenses of the scheme such as staff salaries, legal fees, office expenses, so on and so forth.
This ratio is deducted from the returns and only the balance is transferred to the investors’ accounts. This means this ratio directly impacts the total returns earned by investors. Consequently, a lower TER means higher returns for investors.
For example, if there are two mutual fund schemes with 12 per cent gains each but one has a TER of 1%, while the other charges 2% TER. The total returns will fall to 11 per cent and 10 per cent, respectively.
|AUM ( ₹crore)
|TER for equity (%)
|Reduction of 0.05% for every increase of 5,000 crore
|More than 50,000
For index funds and ETFs
Index funds track the returns delivered by underlying index and investors earn this return minus the TER. Now when the TER is lower owing to higher AUMs, the investors stand to earn higher returns.
The higher AUM is beneficial in case of exchange traded funds (ETFs) as well. This is because a higher AUM ensures greater number of units are traded in financial markets, thus making the mutual fund more liquid.
So, we can say that benefits of lower TER are more evident in the passively managed schemes, since the returns are closer to the underlying index.
In the actively-managed schemes, however, these benefits may be overlooked since investors tend to invest to higher returns, and not to save on expense ratio.
“Actively managed funds are meant to deliver an alpha. So, when the idea is to beat the benchmark index then the possibility of higher return should supersede other concerns,” says Deepak Aggarwal, a Delhi-based chartered accountant and investment advisor.