Uncovered- Costs in Mutual funds.
Mutual funds expenses are the charges levied by the Fund Houses and incurred by the investors who hold mutual fund schemes.
Before investing in mutual funds, it is very vital on the part of the investors to know about these expenses as they can substantially reduce an investor’s earnings and ultimately impact the returns.
Expenses incurred by the Asset Management Companies
There are different kinds of fees which mutual funds charge. These fees are charged for the services rendered by asset management companies to manage the funds and to meet the costs incurred while doing so.
Such expenses are made for meeting various costs as mentioned below:
- advisory fees
- operational costs
- investment management fees
- agent/ sales commissions
- ongoing service charges
- Charges for periodical communication regarding investments
- registrar and transfer agent fees
- legal and audit fees etc.
What are the charges involved in investing in a mutual fund?
There are broadly two types of charges incurred while investing in mutual funds:
- One time charges
- Recurring Charges (Ongoing expenses/Fund Running Expenses)
One time charges:
These are one-time charges levied at the time of investing in a mutual fund scheme or at the time of exiting a mutual fund scheme and are charged as a percentage of investment/encashment amount .
The charges are as follows:
- This is charged at the time of investing in a mutual fund scheme when the units are being purchased.
- The mutual fund would sell the unit at a price higher than the NAV.
At present SEBI has made it mandatory that Mutual Funds cannot charge entry load. SEBI abolished entry loads in August 2009.
- An Exit Load has to be paid when an investor exits from a mutual fund scheme within a short span of holding the same.
- This fee has been levied in order to discourage investors from opting out of the mutual fund schemes before holding them for a sufficient period.
Recurring Charges (Ongoing expenses/Fund Running Expenses):
An AMC incurs various recurring expenses in the process of investing like marketing & distribution expenses, administrative costs, research expenses etc. All these charges are combined together and are passed onto the investor in the form of expense ratio.
Expense ratio tells an investor how much he/she needs to pay AMCs in percentage term every year to manage money.
Example of expense ratio
An investor invests Rs 10,000 in a mutual fund with an expense ratio of 2%. He/she has to pay the fund Rs 200 every year to manage the investment.
If the fund earns a return of 13% and has an expense ratio of 2%, then only 11% returns will be passed onto the investors.
How are these expenses charged?
These are charged on Daily Net Assets of the specific mutual fund. The expenses are deducted every day from the Net Assets of the fund and NAV declared is after adjusting these expenses.
Since reported NAVs are net of fees and expenses, it is necessary to know how much the AMC is deducting in the form of expense ratio.
The guideline rates regarding expense ratio are provided by the regulator and Mutual Funds cannot charge more than the stipulated structure.
Does the expense ratio vary between funds?
Even though the expense ratio structure is stipulated by the regulator, it varies based on the size of the net assets of the fund.
There are two categories of diversified equity funds offered by different mutual fund companies. Fund A has a total size of Rs. 1000 crores and Fund B has a total size of Rs.100/-crores . Does it make the difference in-terms of the total expenses charged by the fund?
It is evident from the above tables that higher the net assets, lower is the expense ratio and lower is the net assets higher the expense ratio. This in turn impacts the returns generated by the respective mutual fund.
Why such costs matter?
All these costs do matter because each rupee that a mutual fund incurs as cost, reduces returns by a rupee, too. Lower costs reflect the operational efficiency of a mutual fund house. All other factors remaining the same, an investor should ideally invest in a scheme which charges a lower TER (Total Expense Ratio) compared to other schemes as higher expenses reduce returns of the fund.
However this does not necessarily mean that a mutual fund which incurs the lowest cost is a good one. It just shows how important it is for an investor to clearly understand mutual fund costs.
A mere 1% difference in costs may not seem that significant, as long as the returns look attractive. However, even a minor 1 per cent difference in cost becomes significant in the long run, as can be seen in the following example.
Consider an investment of Rs.1,00,000 in two funds giving the same returns. The net return after accounting for the costs shows a substantial difference.
Securities transaction tax (STT) on trading done on Stock Exchange for Mutual Funds
This was introduced in India in the Union Budget 2004-05 by Finance Minister P Chidambaram, to stop tax avoidance of capital gains tax.
The STT charge on redemption of mutual funds or ETFs (exchange traded funds) at fund counters reduced from 0.25% to 0.001%, while STT on sale of MFs or ETFs on stock exchanges was cut from 0.1% to 0.001% levied only on the seller.
Debalina Roy Chowdhury
22 September 2017