Assess The Cost of Mutual Funds

11.1 Impact of Expenses

Ask your neighbour how much she pays for cable television service every month and she can probably tell you within a rupee. Ask her how much she pays for money management and she might not have any idea. Yet, she’s probably paying five times more for money management than for cable. If you figure a 1% fee for a 2,00,000portfolio, that’s 2000 a year. And if an advisor is managing her money, she might be paying another 5000 to 6000. After your home, your money management fees may well rank among your top household expenses along with your car payments and food budget.

The tendency of investors to lose track of such a big figure is why money management is such a great business to be in. The fees are spread out over the year so that you hardly notice them. In any single year, your portfolio’s appreciation or depreciation before costs is sure to be greater than the expense bill, so you’re more likely to focus on that. The catch is that, with compounding interest, those fees can add up to a small fortune from the time you buy your first stock or fund to the time you make your last sale.

If all funds cost the same or paying more assured better management, costs wouldn’t matter. Fund expense ratios cut a wide swath, however, and high cost funds don’t have better managers than low-cost funds. Investors too often ignore costs because they make the mistake of driving while looking through the rearview mirror. Investors look at a performance chart and reason that the fund at the top managed to overcome its expense ratio in the past, so why should it be a hurdle in the future? The problem is that for every high-risk, high-cost fund that hits it big, there are 10 more that fail. You seldom notice the ones that fail because they generate little coverage for the same reason that television news reports on lottery jackpot winners do not give equal time to the millions of people who failed to win any money. Highcost funds that made big losing bets often are merged away. That reduces the number of high-expense failures.

Looking through the windshield rather than the rearview mirror, you can see that expense ratios are the clearest thing ahead. You can’t know which sectors will perform well or whether your fund manager will jump ship, but you have a very good idea what a fund’s expense ratio will be. In general, expense ratios show little change year over year.

If the difference between a cheap and an expensive fund only added up to a few ruppes after 20 years, no one would care. However, the power of compounding interest makes small sums grow very large over time. Compare the results of the supercheap fund- called Fund A, which might costs 0.18%, with the reasonably priced fund- Fund B at 0.84%, and rather pricey fund at Fund C 1.95%. If you were to invest Rs.1,00,000 in each fund and each produces 10% annualized returns before taxes over a 20-year period, you would end up spending a little over Rs.10,000 in fees for Fund A, Rs.45,000 inf Fund B, and Rs.91,000 for Fund C. The gap in final rupee values would be even greater because the money that would have been withdrawn to pay fees would still be compounding in the cheaper funds.
Thus, a 1,00,000 investment in Fund A would have grown to Rs.6,49,050 while in Fund C would have grown to Rs.4,56,050, a gap of Rs.1,93,000!

11.2. Understanding Expenses

The expense ratio, also known as the Annual fund operating expenses, is the percentage of assets payable to fund managers as a maintenance fee for management of mutual fund portfolio. If you invest Rs.20,000 in a mutual fund that has an expense ratio of 2%, then you are required to pay Rs.400 as an annual maintenance fee to the fund house.

The fund manager, along with the team of experts, allocates, manages and advertises a scheme to maximize returns and mitigate risks. Typically, the expense ratio is high if the mutual fund asset is small.The annual fee for mutual fund management includes numerous charges that are recovered from the investors on a day-to-day basis.

Types of Mutual Fund Charges
1. Recurring Charges
Also known as a periodic fee, this type of charge can be applicable on a monthly, quarterly or annual basis. Recurring charges usually cover portfolio management, marketing, advertising and other expenses.

A. Management Fees- A fund manager possesses a high level of expertise, relevant fund management knowledge and professional credentials. This is an expense that goes to the fund manager and his team for offering expert services related to the fund and management of the scheme.

Typical management fees are taken as a percentage of the total assets under management (AUM). The amount is quoted annually and usually applied on a monthly or quarterly basis. For example, if you’ve invested Rs1,00,000 with an annual management fee of 2.00%, you would expect to pay a fee of 2000 per year. If management fees are applied every quarter, you would expect to pay a fee of Rs.500 every three months.

B. Operating & Maintenance Fees– One cost of fund ownership that you simply can’t avoid is operating expenses. Every mutual fund-must charge fees to pay for the operational costs of running the fund: advertising cost, employing people to answer the phone lines and operate a Web site, printing and mailing prospectuses, buying technology equipment to track all those investments and customer-account balances, and so on.

Running a fund business costs money! Operating expenses also include a profit for the fund company. (The brokerage costs that a fund pays to buy and sell securities aren’t included in a fund’s operating expenses. You can find this information in a fund’s Statement of Additional Information)
You can find this number in the expenses section of a fund’s prospectus, usually denoted by a line, such as Total Fund Operating Expenses.

2. One Time Charge
As the name suggests, you will be required to pay the charge only once at the time of initiating mutual fund investment. These include Load, Entry load, and Exit Load charges.

Load: This is basically a commission or fee collected by the fund house, usually before or after the mutual fund investment. At times, investors should also pay early withdrawal fees or redemption charges if mutual fund units are pulled out before the expiry of the scheme. There are two types of load that are applicable:

A. Entry Load: The entry Load fee is not applicable on all types of mutual fund schemes. This is a nominal charge levied by the fund house when you purchase a fund unit. These days, mostly load charges are not applied by the fund

B. Exit Load: Mutual Fund exit load is a fee charged by the mutual fund houses if investors exit a scheme partially or fully within a certain period from the date of investment, as specified in the Scheme Information Document. Some schemes do not charge any exit fee.

These charges are levied to discourage investors from redeeming before a certain time period. This is done to protect the financial interest of all investors in the scheme, especially the ones who remain invested. Different mutual funds houses charge different fees for different schemes as an exit load.

Calculation of Exit Load-
Exit load structure of a scheme specifies two parameters – mutual fund fees charged as percentage of the redemption amount at applicable NAVs and the exit load period (period from the date of purchase).

Suppose a scheme charges 1% exit load for redemptions within 365 days from the date of purchase. Suppose you redeem 500 units of a scheme 4 months after your date of purchase. Let us assume that the NAV is Rs 100. The exit load will be = 1% X 500 (number of units) X 100 (NAV) = Rs 500. This amount will be deducted from the redemption proceeds which gets credited to your bank account. So for this, the redemption amount received in your bank account will be Rs 49,500 (Units 500 X NAV Rs 100 – Rs 500 exit load = Rs 49,500.
Exit loads on different types of mutual funds

Mutual fund charges exit load on various equity, hybrid and debt funds. However, certain types of debt funds, like overnight fund and most ultra-short duration funds do not charge mutual fund exit load. Among debt funds, apart from overnight and ultra-short duration funds, many schemes in certain types of debt funds like Banking and PSU funds, Gilt funds etc. do not charge any exit load.

11.3. Importance of Expenses

Expenses matter on all types of funds but more on some and less on others:

• Expenses are critical on money market mutual funds and are very important on bond funds. These funds are buying securities that are so similar and so efficiently priced in the financial markets. In other words, your expected returns from similar bond and money funds are largely driven by the size of a fund’s operating expenses. This fact has been especially true in recent years when interest rates have gotten low.

• With stock funds, expenses are a less important (but still important) factor in picking a fund. Don’t forget that, over time, stocks have averaged returns of about 10 percent per year. So, if one stock fund charges 1.5 percent more in operating expenses than another, you’re giving up an extra 15 percent of your expected annual returns.

Some people argue that stock funds that charge high expenses may be justified in doing so – if they’re able to generate higher rates of return. But there’s no evidence that high-expense stock funds do generate higher returns. In fact, funds with higher operating expenses, on average, tend to produce lower rates of return. This makes sense because operating expenses are deducted from the returns that a fund generates.

Analyse and compare fund’s operating expenses. If a given fund’s expenses are much higher than its peers, one of two things is usually happening: Either the fund has little money under management – and therefore has a smaller group of investors to bear the management costs – or the fund owners are greedy. Another possibility could be that the fund company is inefficiently managed. (Maybe the company rents high-cost, big-city office space and its telephone reps spend half the day making long-distance phone calls to friends!) In any case, you don’t want to be a shareholder of such a fund.

These high-expense funds have another insidious danger built in: In order to produce returns comparable to those of similar funds with lower costs, the manager of such a high-cost fund may take extra risks to overcome the performance drag of high expenses. So on top of reducing a fund’s returns, higher expenses may expose you to greater risk than you desire.

In some cases, a fund (particularly a newer one that’s trying to attract assets) will “reimburse” a portion of its expense ratio in order to show a lower cost. But if (or when) the fund terminates this reimbursement, you’re stuck owning shares in a fund that has higher costs than you intended to pay