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Your Money: How Total Expense Ratio affects mutual fund Net Asset Value

Any mutual fund scheme incurs certain expenses in the running and operations of the scheme. One of the main components of these expenses are investment and advisory fees, which are mainly for the fund manager’s expertise and effort.

These include the marketing and selling expenses incurred by the scheme, agent commissions paid out, brokerage and transaction costs, costs of documentation, and costs of statutory advertisements.
These include the marketing and selling expenses incurred by the scheme, agent commissions paid out, brokerage and transaction costs, costs of documentation, and costs of statutory advertisements.

By Hemanth Gorur

Mutual fund investors typically expect the Net Asset Value (NAV) of the mutual fund scheme they have invested in to appreciate in line with the market prices of the stocks and bonds held by the mutual fund scheme. When this does not happen, investors are surprised.

The culprit is what is called the Total Expense Ratio (TER), or scheme expenses. The daily NAV of any mutual fund scheme reflects these expenses. Let us understand how.

Types of expenses
Any mutual fund scheme incurs certain expenses in the running and operations of the scheme. One of the main components of these expenses are investment and advisory fees, which are mainly for the fund manager’s expertise and effort.

The other main component is what is called recurring expenses. These include the marketing and selling expenses incurred by the scheme, agent commissions paid out, brokerage and transaction costs, costs of documentation, and costs of statutory advertisements.

They also include insurance premiums, audit fees, fees for registrar services, and costs of fund transfer incurred by the scheme, plus certain expenses specific to the type of mutual fund scheme in question. All the above expenses make up the scheme expenses. When taken as a ratio of the scheme’s assets, we get the TER.

Calculation of NAV and TER
The NAV is the current market value of each unit of the mutual fund scheme, which are initially sold at a face value of Rs 10 per unit to investors. The number of outstanding units in the scheme, multiplied by the face value of Rs 10, is called the unit capital.

The funds mobilised from investors are invested in stocks and bonds, which appreciate or depreciate in value, resulting in valuation gains (or losses). Also, the scheme may earn dividend and interest income. These incomes minus the scheme expenses constitute the cash profits (or losses).

Now, net assets of the mutual fund scheme are calculated as:
Net assets = Unit Capital + cash profits (or minus losses) + valuation gains (or minus losses)
NAV = Net assets / Number of outstanding units
TER = scheme expenses / Net assets

TER for various MF categories
As per the SEBI (Mutual Funds) Regulations 1996, there is an established limit for the TER on various categories of mutual funds. For fund of funds schemes investing in index funds or exchange traded funds, the limit for the TER is 1% of the daily net assets, while the limit for those investing at least 65% of the assets under management in equity schemes is 2.25%. The TER limit for all other fund of funds schemes is 2% of daily net assets.
The TER limit for index funds and exchange traded funds is 1% of the daily net assets. For all other open-ended schemes, on the first Rs 500 crore of daily net assets, the TER limit is 2.25% for equity schemes and 2% for non-equity schemes. After the first Rs 500 crore, the daily net assets are divided into further slabs on which the TER limits keep decreasing until it reaches 1.05% for equity schemes and 0.8% for non-equity schemes.

Expenses count
Daily NAV of any mutual fund scheme reflects the scheme expenses
Total expense ratio is the ratio of scheme expenses to net assets
Actively managed MF schemes like equity/ debt schemes have higher TER

The writer is founder, Hermoneytalks.com

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