Quick Reads- Mutual funds and their hidden charges
Mutual funds are safe.
Mutual funds are smart investments.
Mutual funds are not risky.
Mutual funds are simple.
If you’ve ever read any puff piece or seen an ad about mutual funds then you’d be familiar with the adjectives used above. All just good things.
But, are mutual funds really as holy as they’re portrayed to be? Is there no place where they can come get you? Because after all, they’re financial institutions, businesses that are known to take advantage of the fine print.
But as it turns out, Mutual funds are more straight forward than most forms of investments. Mainly because, they’re highly regulated and operate under SEBI’s constant scrutiny.
All the costs incurred, directly and indirectly, by the investors are mentioned without any ambiguity. You can find this data on the fund’s website, as well as any website that allows you to compare funds. Granted, that you wouldn’t be able to find it if you weren’t looking for it. But, more often than not, it’s pretty clearly showcased.
So, what do you have to look out for?
There aren’t many charges that would impact you, as an investor. What you need to watch out for are entry, exit loads and expense ratio. That’s it, just three things.
Entry and Exit loads-
Loads are charges levied by the mutual fund on its investors when they begin their investment in the fund, or, exit it. These charges are calculated as a small percentage of the investment.
Entry load-
This charge has to be paid by the investor while entering into an investment with the fund.
For example, if the NAV of an unit of the fund is Rs.100, you bought 1000 units, and the fund levies an entry load of 2%, then, the entry load would be calculated as-
Total investment * rate of entry load
(100 * 1000) * 0.02 = Rs. 2,000
But in 2009, SEBI, the market regulator, asked funds to do away with entry loads.
One less thing for you to worry about.
Exit load-
This charge is levied on the other end of the investment cycle, when you’re exiting it. Exit loads can either be charged on the complete investment or just on those investments which are being liquidated before the minimum amount of time, which is decided by the fund, for which you have to stay invested. Most funds charge an exit load only on investments which are liquidated under 365 days.
This concept might raise a couple of questions, see if you find answers to them below.
Q. Why does an exit load exist?
There is a lot of money flowing in and out of funds. What this means, is that the fund needs to have enough liquid money — that isn’t tied up in investments — to facilitate this free flow. This effectively reduces the amount of money that is available to them for investment. And, for a company who’s bread and butter comes from generating profits from investments, what good does this idle money do?
That’s right, nothing.
Therefore, exit loads are levied to deter investors from liquidating their investments in short periods, as this allows the fund to plan for more long term investments with greater amounts of money.
And also, a mutual fund, at the end of the day, is just another business and it uses the proceeds from this load to keep its operation, well, operational.
Q. How is this calculated?
It is calculated as a percentage of the total value of your investment which qualifies for this charge, at the time of liquidation.
Funds generally levy around 1% as exit load.
But, this charge is incurred only on those investments that are liquidated before the stipulated period of time.
A little confusing right? I get it.
Let’s say you chose to start an SIP in a fund, which charges 1% exit load on investments that are liquidated before 365 days. Now, this is a monthly SIP and after 14 months, you wish to liquidate it.
In this situation, your first SIP instalment would stay invested in the fund for 14 months, the second 13 months, crossing the all important barrier of 365 days. Only these two instalments would not qualify for the exit load, while, the others would. So, the load is calculated for all the units that were acquired via instalments which, on the date of liquidation, failed to stay invested for more than 365 days.
Expense ratio-
A mutual fund, as mentioned above, is just another business. And just as any other business these funds also have expenses. They have to hire the analysts, people who look at operations, manage legal fees, and handle marketing costs etc. All of this costs money. And expense ratio is a metric that tells us what percentage of the asset under the fund’s management is being consumed for all these tasks.
The greater the expense ratio, the greater the costs.
Now, why should you worry about this?
One mildly compelling reason could be, that it’s your money which is being spent. When you invest in a fund, your money is added to the AUM, and these expenses come out of it.
Greater the expense ratio, greater the fall in your investment’s earning potential.
So if a fund has an expense ratio of 2.5%, it means that your money is earning returns that are 2.5% lower than what they could’ve been. Expense ratios are inevitable, but it does help to choose a fund with a lower expense ratio.
Proceeding with the situation above, if your investment in the fund, with an expense ratio of 2.5%, earns you returns of 10%, then, does it mean that your net return is 7.5%?
Not quite. The NAV of the fund, which is calculated at the end of every day, takes the expense ratio into account, so, the 10% that your investment has earned, is inclusive of this cost.
Different kinds of funds have different expense ratios
SEBI has set a cap on the expense ratios for different kinds of funds.
Equity funds- Max. 2.5%
Debt funds- Max. 2.25%
Index funds- Max. 1.5%
Have you made your first investment yet?
If not, read the series of articles covering why you should invest to how you can get started.
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And, financial literacy is one of those tools. It holds the potential, if harnessed, to change the entire course of a person’s life. Which is why we are working towards making the conversation around it more fun and engaging so that we can empower as many people as we can.
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