Why SEBI's expense ratio overhaul widens active-passive gap

Summary: SEBI’s TER overhaul will alter how mutual fund investors view the different costs associated with it. While the updated rules are expected to benefit passive funds, actively managed funds may need to work harder to deliver alpha.

Mutual fund costs don’t usually grab headlines. Many investors notice them only as a small percentage tucked away in a fact sheet. But SEBI’s December 2025 overhaul of expense ratios is one of those changes that quietly alters the economics of investing, which could have a lasting impact.

On December 17, 2025, regulatory body SEBI announced a major revamp of how mutual fund fees will be calculated, capped and disclosed. On the surface, the headline looks underwhelming: expense ratios are being cut by 10 to 15 basis points across categories. That doesn’t sound dramatic. But scratch the surface and a very different story emerges.

The new rules fundamentally change how costs are structured, and they don’t affect all funds equally. Active fund managers, who rely on frequent trading and higher operational intensity, are likely to feel the squeeze far more than passive funds. For investors, this could widen the already growing gap between active and passive strategies—and force an uncomfortable reassessment of underperforming active schemes.

At the heart of the change is a new way of breaking up fund costs. It sounds technical, but the consequences are very real, and they are reshaping how much value active funds must now deliver to justify their fees.

Understanding the overhaul

Before the December 2025 overhaul, mutual fund expense ratios were bundled under a single ceiling called the ‘total expense ratio (TER)’. Management fees, brokerage costs, statutory levies, distributor commissions, all of them were wrapped into one opaque number. This made it nearly impossible for investors to see exactly where their money was going.

SEBI's new framework pulls this apart. The BER now covers only the core operational costs of running the fund: fund manager salaries, administrative infrastructure, registrar charges and distribution fees. Statutory and regulatory levies such as GST, stamp duty, Securities Transaction Tax, SEBI fees and exchange charges will now be shown separately and charged on actuals.

The result? New TER = BER + brokerage + regulatory levies + statutory levies.

This distinction matters because it exposes which funds are genuinely cheap to operate and which ones rely on hidden charges to justify higher pricing.

Who gets the biggest cuts?

Though the expense ratio ceilings have been lowered across the board, the cuts will vary by fund size.

But here's what matters more than the headline cuts: brokerage limits have been slashed. Cash market brokerage caps fell from 8.59 basis points to 6 basis points (30 per cent reduction). Derivative brokerage has been dropped from 3.89 basis points to 2 basis points (49 per cent cut). For funds that trade frequently, this is a significant squeeze.

In addition, SEBI removed a five-basis-point allowance that fund houses could claim for exit-load schemes. That fee corridor is now closed.

The modest but real savings for investors

How much will you actually save? According to Value Research analysis, genuine cost savings are estimated at 6-8 basis points per year for most investors. The rest of the headline reduction comes from removing statutory levies from the BER calculation, something that mutual fundinvestors were already paying, just bundled.

Over a 10-year period with a Rs 10 lakh lumpsum investment (assuming 12 per cent annual returns before costs), a 10 basis point reduction translates to Rs 25,600 in additional wealth. Over 20 years, that compounds to Rs 1.46 lakh.

These are not trivial sums. However, they assume consistent savings. Statutory levies can fluctuate. GST rates can change. Market volatility affects brokerage costs. The transparency from separating BER from levies is genuine progress. The absolute savings are real but incremental.

Why active funds feel more pain

Active mutual fund managers buy and sell stocks frequently, with the aim to outperform benchmark indices. This trading incurs brokerage costs, which are deducted from the fund's returns. Under the old framework, fund houses could absorb these costs within the broader TER ceiling.

The 30 per cent cut in cash-market brokerage and the 49 per cent reduction in derivative brokerage mean active fund managers now have much less flexibility. Consider the practical impact: a fund manager with a Rs 5,000 crore portfolio executing 200 trades per month faces a 30 per cent reduction in per-trade brokerage allowance. The costs still exist; they simply must be absorbed within a tighter margin.

Passive funds, by contrast, require minimal trading. An index fund tracking Nifty 50 trades only during rebalancing or constituent changes. Brokerage costs for passive funds are negligible. The new rules, therefore, benefit passive funds more. Their cost advantage just expanded.

Passive funds: The expanding cost advantage

Passive mutual funds were already winning the cost battle. A large-cap index fund typically charges an expense ratio of 0.02 per cent to 0.1 per cent.  Their value proposition is simplicity and low cost.

With active fund costs under pressure and brokerage caps tightened, the cost gap widens. An active large-cap equity fund must operate within a 1.05 per cent TER if it manages assets of more than Rs 50,000 crore. A passive large-cap index fund typically operates at 0.30 per cent. The active fund's room to cover trading costs and fees is squeezed, discouraging active fund managers from taking frequent active calls and delivering outperformance.

This regulatory pressure pushes the active-versus-passive decision further toward passive, especially in large-cap segments, where active underperformance runs 65-73 per cent over 10-year periods.

Does active management still make sense then?

The new expense regime doesn't eliminate active fund investing. Active funds still win in small-cap and mid-cap segments, where market inefficiencies create opportunities for skilled managers to outperform. The question is sharper: an active fund manager must deliver at least 8 basis points of annual outperformance just to break even with passive. Given structural cost headwinds, that bar is higher than before.

What should you do?

Step 1: Calculate your portfolio's current weighted average expense ratio. Add up the BER of all holdings. When April 1, 2026, arrives, cross-check against SEBI's new ceilings.

Step 2: Estimate your 10-year savings. Using the Rs 10 lakh investment and 12 per cent return formula above, calculate what 6-8 basis points means for your wealth.

Step 3: Reassess active fund performance. For active funds in your portfolio, verify if the track record suggests outperformance of at least 8 basis points annually. If not, the case for active weakens.

The bottom line

SEBI’s TER overhaul brings transparency but also complexity. Statutory levies can spike during volatile periods. GST changes are possible. The April 1, 2026 implementation leaves time for AMCs to adjust. Some may shift variable trading costs into separate levy buckets.

Investors should monitor updated expense disclosures closely when the rules take effect.

To stay up to date with more such news on mutual funds, keep reading Value Research.

Also read: SEBI plans major mutual fund overhaul, lower expense ratio