Category: Investment Management

Uncovered- Costs in Mutual funds.

Title: Understanding Mutual Fund Expenses and Their Impact on Returns

Investing in mutual funds comes with its share of expenses, and these costs can have a significant impact on the returns investors ultimately earn. It is crucial for investors, whether new or experienced, to be well-informed about these expenses. Mutual fund expenses encompass the charges imposed by fund houses, which are eventually borne by the investors holding these funds.

Types of Expenses Incurred by Asset Management Companies (AMCs)

Mutual funds levy various types of fees, all associated with the services provided by AMCs to manage the funds and cover operational expenses. These charges include advisory fees, operational costs, investment management fees, agent/sales commissions, ongoing service fees, charges for periodic communication about investments, registrar and transfer agent fees, legal and audit fees, and more.

Charges in Mutual Funds

The expenses incurred by investors in mutual funds can be broadly categorized into two types: one-time charges and recurring charges (ongoing expenses/fund running expenses).

One-Time Charges

    • Entry Load: This charge, once common, was levied when investors purchased units of a mutual fund scheme. However, the Securities and Exchange Board of India (SEBI) abolished entry loads in August 2009.

    • Exit Load: Investors must pay an exit load if they redeem their mutual fund units shortly after acquiring them. This fee discourages investors from exiting the scheme prematurely.

Recurring Charges (Ongoing Expenses/Fund Running Expenses)

Mutual fund AMCs incur various recurring expenses, including marketing and distribution costs, administrative expenses, research costs, and more. These costs are combined into what's known as the expense ratio, which represents the annual percentage of an investor's assets that must be paid to the AMC for fund management. For example, if an investor places Rs 10,000 in a fund with an expense ratio of 2%, they will pay Rs 200 annually to the fund for management.

Expense Ratio Calculation

The expenses are calculated daily based on the net assets of the mutual fund. The Net Asset Value (NAV) reported to investors is after these expenses have been deducted. Regulators provide guidelines for the expense ratio structure, ensuring that mutual funds do not exceed the stipulated limits.

Expense Ratio Variations

While regulators establish the expense ratio structure, the actual ratio may vary based on the size of the mutual fund's net assets. Larger funds tend to have lower expense ratios, while smaller funds have higher ratios.

Importance of Managing Costs

Mutual fund costs are a crucial consideration because every rupee spent by a mutual fund as a cost directly reduces the returns by an equal amount. Lower expenses reflect the operational efficiency of the mutual fund. All else being equal, investors are advised to choose schemes with lower Total Expense Ratios (TER) as higher expenses diminish fund returns.

The Significance of Minor Differences in Costs

Even a seemingly minor 1% difference in costs can become substantial over time. For instance, if two funds yield the same returns, the net return after accounting for costs will show a significant disparity. In the long run, the impact on returns can be considerable.

Securities Transaction Tax (STT) in Mutual Funds

STT was introduced in India to curb the avoidance of capital gains tax. It is important to note that the STT charges for trading on stock exchanges in the context of mutual funds have undergone changes, with reduced rates applicable for redemptions and sales.

Understanding mutual fund expenses is paramount for investors, and it's essential to consider the impact of these charges on investment returns.

Debalina Roy Chowdhury Dilzer Consultants