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Hidden Costs in Mutual Funds
The costs involved in any investment determine the returns it can generate. In the case of mutual funds, the daily volatility of NAVs hogs the news, but the costs are never adequately addressed nor fully understood. These costs vary from fund to fund, just like NAVs and their impact on different categories of funds is different.
The costs involved in mutual funds can be broadly classified into two categories:
* Entry/exit loads: These are one-time costs incurred when you enter or exit a fund, and are charged as a percentage of your 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 your returns by an equal amount. This is not to say that the mutual fund which has the lowest costs, 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.10,000 in two funds giving the same returns. The net return after accounting for the costs shows a substantial difference. Returns (%) Costs (%) Net return (%)
Rs.10000 after
10 yrs
20 yrs Fund A 15 2 13 Rs.33945 Rs.1,15230 Fund B 15 1 14 Rs.37072 Rs.1.37435
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 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, the 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 you an idea of its portfolio reshuffle policy. |
