Hidden costs in Mutual Funds

In selecting mutual funds, most investors care to check the expense ratio; the standard measure of how costly a fund is to own. But that is not the only item of cost. There are other costs as well, that are not reported in the expense ratio and are related to the buying and selling of securities in the portfolio. Such expenses can make a fund two or three times more costlier than it is advertised. The average investor can't really even begin to get a strong grasp on these additional costs.

The costs involved in mutual funds can be broadly classified into two categories:

Entry/exit loads: These are one-time costs incurred when one enters or exits a fund, and are charged as a percentage of investment/encashment amount.

Expense ratio: It comprises some of the major expenses that a fund incurs:

i) Investment management and advisory fees
ii) Transfer agent fee and expenses
iii) Custodian fees
iv)  Various operating expenses

Why costs matter?

The answer is obvious- each rupee that a mutual fund incurs as cost, reduces returns by an equal amount. This is not to say that the mutual fund which incurs the lowest cost is always better. It just indicates how important it is for an investor to clearly understand mutual fund costs.

On the face of it, a mere 1% difference in costs may not seem significant, as long as the returns look attractive. However, even a seemingly minor 1 per cent difference in cost is significant in the long run, as in the following example.

Consider an investment of Rs.200,000 in two funds giving the same returns. The net return after accounting for the costs shows a substantial difference. 

How to determine fund costs?

Entry/exit loads and expense ratios of all mutual funds are regularly reported in the financial press and on websites. The information is also easily available directly from the funds.

There are certain other costs which mutual funds incur that are more difficult to determine. These include the commission and brokerage fee paid when shares, bonds and other securities are bought and sold. The extent of these costs varies directly with how much, and how often, a fund reshuffles its portfolio. Thus, higher the portfolio churn (reshuffle), the higher the costs. For funds with higher turnovers, transaction costs can have a major impact on the cost of doing business. While this invisible cost is automatically reflected in the fund's performance / results, that is no reason to ignore it. A look at the investment style and policies listed in a fund's prospectus should give one an idea of its portfolio churn.

Conclusion

Excessively high costs can eat into returns and can cost a fortune in lost profits over the long run. The first step to getting it right is to understand exactly what it costs to run your investments and then to make them as simple and transparent as possible.