Understand the charges on Mutual Funds

As an investor, it is very important to know what are the charges involved in investing in mutual funds. When your money is handled by a team of experts - stocks are bought and sold on your behalf, periodical communication is sent on investments, charges are given to the intermediaries etc, it does not come for free. All these expenses come with a cost...Read on..

There are broadly two types of charges applicable on Mutual Funds:

1.One time charges:

1.1 Entry Load
Some Asset Management Companies (AMCs) have sales charges, or entry loads, on their funds to compensate for distribution costs. Funds that can be purchased without a sales charge are called no-load funds. Entry load is charged at the time an investor purchases the units of a scheme. The entry load percentage is added to the prevailing NAV at the time of allotment of units. e.g. if the NAV of a fund is INR 100 and the entry load is 2% and you are here to buy 20 units by paying INR 2000 (20*100), you will be actually not allotted 20 units. Instead, just before allocation of units, the NAV of the fund will be assumed as 102 (2% as entry load on NAV) and you will be allocated 19.6 units (2000 / 102). Look for the entry load before comparing two similar funds. At present Mutual Funds cannot charge entry load.

1.2 Exit Load
Exit load is charged at the time of redeeming or transferring an investment between any two schemes. Remember that switching funds or using STP (Systematic Transfer Plan) for moving funds systematically entails exiting one fund and entering the other - thus inviting entry and exit loads as applicable in the respective funds. The exit load percentage is deducted from the NAV at the time of redemption (or transfer between schemes). A Mutual Fund cannot use these charges for paying commission or meeting any of their expenses. This money should be invested back to the fund, which would benefit the investors who remain invested for long term.
The mutual fund would buy back the units at rate lower than the NAV. There are no fixed exit loads which are charged. It varies based on the scheme. The current practice is the funds could charge any way from 0.50% to 3.00% depending on the holding period. If the investors continue to hold the investment beyond the specified period, no exit load is charged.

For eg: An equity fund currently at an NAV of INR 100 charges exit load of 1.00% if the investor exits within 1 year of investment. If an investor wants to sell his mutual fund units, which were bought 10 months back, then the redemption NAV for such investor would be INR 99

1.3 Transaction Fees / Charges 
These charges are one time charges applicable when the money is invested. This is applicable for the investments of over Rs. 10,000/-. This would be paid to the distributor/intermediary who is selling the fund.
The transaction charges of Rs. 100/- is charged for the SIP commitment of Rs. 10,000/- or above (not monthly SIP amount). The SIP transaction charges are deducted over 4 installments starting from 2nd installment to 5th installment.

The Transaction charges may be higher in case the investor is a new investor.


2.Recurring Charges (Ongoing expenses/Fund Running Expenses)

2.1 Expense Ratio

The only ongoing charges laid down in mutual funds are the running expenses, defined by Expense Ratio. Expense ratio is the percentage of total assets that are spent to run a mutual fund. Expense Ratio is the one an investor should be more concerned about, since this expense is recurring in nature - whether you make profit or loss out of your investment. 

Following are the key points of an Expense Ratio

1) These expenses involve the fund management fee, agent commissions, registrar fees, and selling and promoting expenses. 
2) The largest component of the expense ratio is management and advisory fees. From management fee an AMC generates profits. 

3) Then there are marketing and distribution expenses. 

4) All those involved in the operations of a fund like the custodian and auditors also get a share of the pie.

5) The expenses are charged on Daily Net Assets of the specific mutual fund. The guideline rates are given by the regulator and Mutual Fund Houses cannot charge more than the stipulated structure. 

6) The expenses are deducted every day from the Net Assets of the fund and NAV declared is after adjusting the expenses.

7) Expense ratio states how much you pay a fund in percentage term every year to manage your money. For example, if you invest Rs 10,000 in a fund with an expense ratio of 1.5 per cent, then you are paying the fund Rs 150 to manage your money. In other words, if a fund earns 10 per cent and has a 1.5 per cent expense ratio, it would mean an 8.5 per cent return for an investor. Funds' NAVs are reported net of fees and expenses, therefore, it is necessary to know how much the fund is deducting.

8) Since this is charged regularly (every year), a high expense ratio over the long-term may eat into your returns massively through power of compounding. For example, Rs 1 lakh over 10 years at the rate of 15 per cent will grow to Rs 4.05 lakh. But if we consider an expense ratio of 1.5 per cent, your actual total returns would be Rs 3.55 lakh, nearly 14 per cent less than what would have been achieved without any expense charge.
9) Different funds have different expense ratios. But the Securities & Exchange Board of India has stipulated a limit that a fund can charge. 

10) Equity funds can charge a maximum of 2.5 per cent, whereas a debt fund can charge 2.25 per cent of the average weekly net assets. Fund Houses can charge lower to beat competitive fund houses on NAV front. As an example, ICICI Prudential Value Discovery Fund is an equity fund and can charge up to 2.5% expenses. However, it currently charges only 2.26%

11) Expense Ratio also varies with the Asset Size under management (often referred to as AUM). The larger the AUM, the lesser the Expense Ratio.

Summary

To sum up all the charges, this chart may help you:

While Entry / Exit Loads are significant while comparing peer funds, it is the Expense Ratio which is vital, especially in case of debt funds. Till last year, when bond funds were giving a whopping 14.5 per cent return, nobody cared about expenses. But that's history now. The days of double-digit returns are over. With an all-round reduction in interest rates, bond funds are expected to give a return of 7-9 per cent this year. Thus, in a low yield universe, every penny will count. And as expenses are deducted from the fund before calculating the NAV, it is likely to be a major differentiating factor among bond funds where returns vary marginally.
In case of actively managed equity funds, the issue of expenses is more complicated. The wide divergence of returns between 'good' and 'bad' funds makes the expense ratio secondary. But here too, if you find two similar funds, the expense ratio can be a good differentiation. Perhaps, more important is the fact that expenses are charged at all times. Whether a fund generates positive or negative returns, expenses are always there.

Cheers

Manoj Arora
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