Mutual fund charges are invisible to all but savvy investors. This is, in fact, true not just for mutual funds, but nearly all investment products, even your savings account. Now, what do we mean by invisible? We mean that the cost is not explicit or fixed; so it’s not as if you pay an asset management company (AMC) a mutual fund fees upfront before you invest and then pay a subscription fee each month or year for your investment in the fund.
Instead, a percentage of your investment is simply deducted at a certain date during the year. It is common for new investors to not know this at all, which is it is common for financial experts to be asked how mutual funds make money. Well, they make a lot of money. Let’s find out what the costs are, how they affect your returns and how you can reduce your expenses.
An AMC has the same expenses as any other company. It has a large workforce, operational and administrative expenses, runs large advertising and marketing campaigns, etc. These are charged to the customer, of course, through the Total Expense Ratio (TER), which is currently capped at 2.5% in metros and tier-1 cities (it can be up to 0.3% higher in case of regular plans sold in tier-2 and tier-3 cities to cover higher selling expenses). GST is also to be paid on investments.
Of course, a lower expense ratio or TER means higher returns as the net asset value (NAV) of a mutual fund excludes all liabilities, including TER.
Large funds tend to have lower TERs, as the Securities & Exchange Board of India’s guidelines clearly states that as AUMs increase, cost of running the fund should decrease. According to SEBI, the limit on TER is to be calculated as follows:
| Weekly Net Assets (Avg) ||Equity Schemes (Upper Limit)|| |
Debt Schemes (Upper Limit)
|Up to Rs. 100 crore||2.50%||2.25%|
|Subsequent Rs. 300 crore||2.25%||2.00%|
|Subsequent Rs. 300 crore||2.00%||1.75%|
|Remaining assets|| 1.75% ||1.50%|
Passively managed funds are cheaper to run than actively managed funds. Therefore, index funds or exchange-traded funds have much lower TERs than schemes managed by a fund manager.
Moreover, all mutual funds have regular and direct variants. The former is more expensive than the latter, as you pay a commission to a broker or distributor. Your neighbourhood financial agents and even most websites such as Scripbox and Funds India all sell regular plans and earn commissions on them.
These are nothing but commission-free variants of regular mutual funds (read the full comparison). There is usually a difference of 1% to 1.5% between direct and regular TERs. While this may not seem like much, investing in direct mutual funds could allow you to grow your portfolio by an additional 40% over the long term. Direct funds were launched in 2013, and today there are over 2000 direct plans to choose from.
The mutual fund industry is yet to gain maturity in India; much efforts need to go into extending it to tier-2 and -3 cities. Therefore, SEBI has allowed AMCs to charge an additional 30 basis points (100 basis points is one percentage point) if at least 30% of new inflows or 15% of assets under management (AUM) come from beyond the top 15 cities. This allows mutual funds to charge up to 2.8% (as opposed to 2.5%) on equity schemes. However, if the number, at any time over the subsequent 12 months, drops below 30%, the AMC must return the 0.3% in charged in fees.
Mutual funds may have mutual fund fees/charges in addition to the TER. These charges are typically loads, which are one-time expenses you may have to bear when you first invest or when you sell your funds.
Transaction charge: The transaction charge is a small fee AMCs are allowed to charge investors at the time of making an investment. This fee is Rs. 150 for first-timers, in case you invest over Rs. 10,000, but is Rs. 100 if you’re an existing investor. If you invest less than Rs. 10,000, there is no transaction charge. You’re probably wondering, though, what if I invest in a Systematic Investment Plan? Well, if you’ve invested more than Rs. 10,000, a charge of Rs. 100 is applied equally (Rs. 25 x 4) during your second, third, fourth and fifth installments. In case you’re wondering if this is the ‘entry load’, this isn’t; instead, it’s a cheap replacement. You see, SEBI used to allow AMCs to charge an entry load of up to 2.25% until they banned the practice in August 2009!
Exit Load: Think of exit loads as penalties for ‘early redemption’. This applies to all mutual funds, with the exception of liquid funds (where the whole point of investment is the flexibility of exit). So, how do exit loads work. Let’s say your mutual fund has an NAV of Rs. 100 and the exit load is 1%. If you redeem Rs. 100,000, you will receive Rs. 99,000. The remaining Rs. 1000 is the exit load. The exit load is meant to deter early withdrawal, as mutual funds (particularly equity mutual funds) are long-term investments. Exit loads are typically between 1% and 3%, and apply to investments with a duration of less than one year.
One thing to remember here is that there are exit loads on every SIP installment, too. So, let’s say you’ve had a SIP of Rs. 10,000 going out of your account for the past 12 months, but now wish to withdraw all your money because the market is doing well. You will be charged an exit load on all but your first SIP. Why? Because the other 11 installments were for less than one year.
Well, there are always some small incidental charges. For example, if you’re putting your money in exchange-traded funds, you’ll need a demat account; some brokers and distributors also require you to open a demat account (if you’re interested in a completely paperless experience, try out our app, Jama). There is also a security transaction tax, but this is a minor cost, and not applicable to debt and debt-oriented schemes.
You surely shouldn’t pick a fund based exclusively on its cost (‘How to pick a mutual fund’). Would you be stuck with a losing scheme simply because it has a low TER? Certainly not. Lower costs are an indication of the operational efficiency of an AMC, but don’t provide any insight into potential returns. Go instead for schemes that offer good returns, after TER. And whatever you do, invest only in direct plans.
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