In his 2017 Annual Shareholder Report, Warren Buffett devoted a complete passage lauding the efforts of John Bogle in creating wealth for mutual fund investors. What is unique about this commendation is that Buffett represents the finest traits of an active fund manager while John Bogle is the founder of Vanguard Funds, which is the world’s largest passive investor. Vanguard has built around the premise that it is hard to beat the market and much harder for an investor to identify a fund or a fund manager who can consistently beat the market. Therefore, Vanguard has always believed in the merits of passive investing via index fund and index ETFs.
What Buffett was actually trying to say was that in the American markets, Alpha has been hard to come by. Therefore, passive fund managers like Vanguard had rendered a great service to investors by reducing their cost of managing funds via index funds. An index fund just creates a portfolio that mirrors an index and hence it does not spend too much time and resources on fund selection and fund monitoring. That means; lower costs and these lower costs are passed on to the investors in the form of lower total expense ratio (TER). According to Buffett, Vanguard had actually saved hundreds of billions of dollars for American investors by charging lower costs and still helping investors to create the wealth in the long run. Let us now dwell on the concept of total expense ratio (TER) in detail.
What is the idea of Total Expense Ratio (TER) all about?
Many investors tend to mistake the TER with the entry load and the exit load. These are entirely different concepts. An entry load used to be charged by mutual funds till 2009, when SEBI came out and banned explicitly charging entry loads to investors. The distributor could charge a fee with the consent of the investor or the investor had the option to go for a direct investment. Entry load, in the strict sense, does not exist any longer although distributors are allowed to charge a fee. Exit loads are charged by the fund when an investor exits a fund before the completion of 6 months or 1 year as the case may be. The idea is that when investors leave a fund, they tend to get subsidized by investors who stay on in the fund. The exit load is designed to make the existing investors contribute towards this purpose. But what about total expense ratio (TER).
The total expense ratio (TER) is distinct from the entry load and the exit load. The TER is debited to the fund AUM by the fund to cover and defray its regular costs. What are the costs that we are referring to? For example, mutual funds have to pay brokerage when they trade in stocks and bonds. Then there are statutory costs like STT, GST, Stamp Duty, Turnover fees etc. The fund incurs expenses on marketing and promotion of the fund which is also debited to the AUM. Then there are routine administrative costs like manpower costs, office costs, audit costs, legal fees, registrar fees, custodian fees etc. All these will also get debited to the AUM of the fund. The total value of all these debts is referred to as the total expense ratio (TER) of the fund. While the TER is expressed on an annual basis as the percentage of AUM, it is debited to the NAV on a daily basis to reflect a clear picture.
There are limits to the Total Expense Ratio
SEBI has set upper limits for the TER for different categories of funds. For example, the peak TER for an equity fund cannot cross 2.5% of the AUM. It has to be less than 2.25% of the AUM of debt funds and a maximum of 1.5% of AUM for index funds. Also, SEBI has prescribed a slab rate for TER where the total TER goes down as you move to higher slabs of the AUM That is why, as you go higher in the AUM slab, your effective TER reduces.
The TER makes a big difference to the eventual effective returns of a fund. For example, there is a difference of 100-125 basis points between an equity diversified fund and an index fund. Unless the fund managers are able to make much more than this spread, they are not going to impress investors. As alpha opportunities compress in the market, TER becomes a lot more significant.