Costs involved in mutual fund investing
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.
1. What are the expenses that mutual funds charge to investors?
Asset management companies (AMCs) manage the assets of the mutual funds and take the investment decisions. AMCs charge investors for professional fund management and regular operational costs which include investment management and advisory fees, sales/agent commissions and ongoing service fees, legal and audit fees, registrar and transfer agent fees, fund administration expenses, and marketing and selling expenses. All these expenses charged to an investor are together called the 'total expense ratio' (TER); it is an annual charge on AUM in percentage terms. According to the Securities and Exchange Board of India's (SEBI's) guidelines, TER needs to be lower as AUM increases. The net asset value (NAV) of a mutual fund scheme is net of all liabilities including TER, and hence a lower TER results in higher returns and vice versa. In a recent circular, SEBI has included service tax under 'cost to investors' (earlier paid by AMCs).
2. How is total expense ratio calculated?
Total Expense Ratio (TER) is calculated as follows - TER = (Total expenses during an accounting period) * 100 / Total net assets of the fund.
3. What are the recent changes introduced by SEBI under TER?
SEBI has recently come out with a circular that AMCs would be allowed to charge an additional 30 bps of TER on the condition that the new inflows from beyond top 15 cities are at least 30% of gross new inflows in the scheme or 15% of the scheme's AUM (year-to-date), whichever is higher. In other words, TER may go up to 2.8% instead of 2.5% for equity schemes. However, the additional TER will be clawed back if inflows from beyond top 15 cities are redeemed within a period of one year from the date of investment. The circular also stated that mutual funds shall annually set apart at least 2 bps on daily net assets within maximum limit of TER for investor education / awareness initiatives
4. What are mutual fund loads?
Loads are one time charges which are levied either at the time of investing in or at the time of exiting a mutual fund scheme. These are over and above the TER.
A Entry load: It is a front-end charge deducted from the NAV at the time of investing in a mutual fund scheme. SEBI abolished entry loads in August 2009. These charges were as high as 2.25% for equity funds prior to the abolition.
B. Transaction charge: Starting August 2011, SEBI has allowed AMCs to collect a nominal amount as a one-time transaction fee. It ruled that for a first time investor, AMCs can collect Rs 150 as a fee if the investment is more than Rs 10000 while the fee for an existing investor would be Rs.100; no fee can be charged for any amount less than Rs.10000. In the case of Systematic Investment Plans (SIPs), where the total commitment towards the SIP is more than Rs. 10000, a transaction charge of Rs. 100 will be levied payable in four equal installments starting from the second to the fifth installment.
C. Exit Load: It is a charge levied when an investor redeems / sells his units in a short span of time since he made the investment. Mutual funds charge exit loads to deter investors from leaving mutual fund schemes before holding them for a sufficient period. Various categories charge exit loads depending on pre-defined holding period cutoffs.
For instance, in a liquid fund, most schemes do not charge an exit load as investors invest in these funds for a shorter duration. For most other categories, the exit load ranges between 1-3% depending on the exit time frame specified by the fund.
5. What are the other costs that need to be borne by mutual fund investors?
There are also some indirect costs which an investor has to bear throughout the investment tenure. For instance, in exchange traded funds (ETFs), an investor has to pay for opening a demat account, for maintenance of the account, and brokerage charges. Mutual funds are required to pay a security transaction tax while buying and selling stocks, which is ultimately borne by investors.
6. Do all mutual funds have the same structure for expense ratio?
Investors should note that different funds have different expense ratios. Passively managed funds like index funds or exchange traded funds (ETFs) have lower expense ratio than actively managed funds. This is because passively managed funds track the underlying index and do not require a fund manager to take active investment calls. SEBI recently asked mutual funds to launch schemes under a single plan and ensure that all new investors are subject to a single expense structure. Currently, TER varies according to the investment amount (which depends on the plan - retail, institutional and super-institutional). SEBI also asked mutual funds to provide a separate plan for direct investments (investments not routed through a distributor) in existing as well as new schemes. These separate plans shall have a lower expense ratio excluding distribution expenses and commission, and no commission shall be paid from such plans.
7. How do costs affect returns on mutual fund?
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 compared to peers as higher expenses reduce returns of the fund.