Thread by @tradersushma

The dark side of Total Expense Ratio in Mutual Fund industry

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1/21

What is Total Expense Ratio (TER)?

It is the ratio of total expenses incurred by an AMC divided by its total asset under management. It represents per unit expense of an AMC. 2/21

Eg.

If TER of a MF scheme is 2%, it means that 2% of investment corpus (AUM) is utilised by AMC to fund its expenses like operating cost, management fees, advertising costs etc. 3/21

MF cos fund their expenses not out of any profit earned by business. It takes some % share from your investment corpus as its fee to maintain your portfolio. It acts as an agent who manages your funds & charge fees for it. 4/21

Irrespective of whether your investment makes profit/loss, MF co has to cut its share of expenses from the asset base to run its business.

TER is a recurring cost.

It is charged annually on your investment corpus i.e., u have to pay that 2% on your investment every year. 5/21

It is deducted on a daily basis from investment value before daily NAV is calculated.

E.g.

Suppose u have invested Rs 1 lac in a MF scheme whose TER is 2%.

Your invested value is Rs 100100 today. So, after market close TER will be [ (2/100) * 100100] / 365 = Rs 5.48
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Suppose next day your investment becomes Rs 100500, then TER will be [ (2/100) * 100500] / 365 = Rs 5.51

Formula of TER is ~

Total Expense Ratio (TER) = Total expenses / Total asset under management
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e.g.

Suppose an AMC has total AUM of Rs 100 & expenses to run that AMC is Rs 2 so ER is 2/100 = 0.02 or 2%.

Fund house will first deduct its fee of Rs 2 & then invest balance amt of Rs 98. So, AMCs need to make higher returns in order to make profit on your investment. 8/21

Note here that this fee of Rs 2 will be charged in spite of profit/loss in your portfolio.

Usually, AMCs cannot change their TER without informing investors. If fact SEBI has put an upper limit on TER which any AMC can charge depending upon their total AUM base. 9/21

For equity funds, the maximum TER that can be charged is 2.25%. For debt funds, the maximum is 1.75%.

How does AMCs perform during bear market?

TER depends upon the fund size. Higher the AUM lower is the TER & vice versa i.e., fund houses with higher AUM have lower TER. 10/21

AUM of equity funds fluctuates with market volatility. When stock prices increase portfolio value increase thus increasing their AUM. Increased AUM will result in higher collection of fees. So, its all-hunky dory for both investors & AMCs during bull market. 11/21

But what happens in bear market?

Suppose stock market enters bear phase & continues to remain so for 5 yrs.

What will happen to your AMC?

Their total investment value (AUM) will fall due to fall in stock prices. 12/21

Since denominator (AUM) decreases & numerator (Expenses) is same, TER shall increase automatically. Now, AMCs will have to increase their TER to continue to operate their business although increase has to be under the max limit prescribed by SEBI. 13/21

Suppose AMC is charging TER up to max limit prescribed be SEBI & equity market is still in bear phase with stock prices decreasing further. Investment corpus of AMC also lowers correspondingly due to which TER fees collected by AMC also decreases. 14/21

Mind u, we have not considered redemptions yet which is very common in bear market. With investors redeeming their units, AUM shall decrease further lowering the fees collected by AMCs. 15/21

If this situation persists, it will become difficult for AMCs to meet its operating expenses & run its business due to low collection of fees.

Hence prolonged bear market is harmful for AMCs & very few fund houses will be able to survive this phase. 16/21

Let us understand with help of an example.

Suppose U have invested Rs 100 in a fund house.

Market corrects 10% in 1st year. Your portfolio comes down to Rs 88.

Market again corrects 10% next year & your PF value lowers to Rs 77.8.
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Market corrects 25% further & subsequently consolidates at the same level for 2yrs. Your portfolio becomes almost half & TER charges collected by fund house also halves.
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How can a MF co continue to run its business when its income reduces by 50%?

Weaker AMCs will be crushed in such situation.

If any bear market lasts for 15 years, 95% of the mutual funds will go out of business due to reduced fund value and hence insufficient AMC fees! 19/21

Hence be well-informed before entrusting your money to any fund house for long term. Ensure that they r strong enough to survive the hardships of prolonged bear market in addition to providing decent returns over time. 20/21

That's all for this thread. If u liked it do retweet for wider audience. Also follow @tradersushma for more such trading, investing & personal finance related insights.

Thank You!
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