Costs Associated with Mutual Funds
Mutual funds are a great investment option for any investor. However, mutual funds come with costs as there are people managing our money. And thus it is essential for us to understand important costs associated with mutual funds as they can deplete the returns.
In this article, we will learn about two important costs associated with mutual funds. So, let’s dive in.
Expense Ratio
Every transaction in the market has a cost associated with it. We must pay brokerage, stamp duty, GST, etc. for each transaction. On top of that mutual fund houses also hire research analysts and fund managers to effectively manage the funds. They even spend on marketing, advertising, and paying commissions to brokers and distributors. To carry out all these activities they need money, and on top of that, they have to earn profit.
So, to cover all these expenses, mutual funds charge fees known as Total Expense Ratio (TER) or Expense Ratio. This ratio is calculated as a percentage of total investment. We have explained the detailed calculation in the next section of the article.
So basically, the expense ratio is the money charged for managing our funds. It is one of the most important factors in mutual fund analysis. A high expense ratio can lower your returns and it will have a drastic impact on long-term compounding.
Expense Ratio and NAV: A Detailed Calculation
Suppose you invest in a mutual fund whose expense ratio is set at 1%. This means every year 1% of your investment will go to the fund house (as a fee) for managing your money.
If you invest Rs. 1,00,000 and the NAV at that time is Rs. 10, then you will get 10,000 units.
Now, the expense ratio is 1%, which comes out to Rs. 1000 (1% of Rs. 1,00,000). But Rs. 1000 has to be paid throughout the year. So, Rs. 1000 divided by 365 gives you Rs. 2.74 per day.
Now, if the NAV of the fund goes up by 1% the next day, then your NAV is Rs. 10 + 1% = Rs. 10.1, which gives the total value as 10.1 * 10000 = 101000.
But the AMC will deduct their Rs. 2.73. So they will deduct it from your 101,000.
Now 101000 - 2.73 = 100997.3
100997.3 / 10000 = 10.09973
10.09973 is the NAV that you’ll see after the first day. AMCs release NAV after deducting the expenses.
In this article, we will see that mutual funds come in two plans:
- Direct plan
- Regular plan
A direct plan is one where the investor buys the mutual fund directly from the AMC. In contrast, a regular plan involves someone in the middle. They can be the agents or distributors who sell this fund.
The expense ratio of regular plans is always higher than that of direct plans. The additional expenses are distributed among the agents from whom investors buy mutual funds.
As you can see below, there is a list of funds from different AMCs with their expense ratios. Each fund has a regular and direct plan option. The expense ratio for the regular plan is higher than the direct plan.
You might think it's just a few percentage points higher than the direct plan, but over a long period, this cost gets compounded and can result in a huge depletion of wealth. Thus it is always advised to buy direct plans over regular plans.
Let’s take an example. If you invest Rs 1 lakh for 35 years with two different expense ratios of 1.85% and 1.01% assuming a pre-expense return of 12.5%. After 35 years you will have Rs. 45 lakh with a lower expense ratio of 1.01% and Rs. 34.53 lakh at an expense ratio of 1.85%. So just a 0.84% difference in expense ratios will erase more than Rs. 10 lakhs from your portfolio.
As you can see from the above chart, in the long term, a small difference in absolute returns can make a huge difference.
You can find the expense ratio of any mutual fund in the Overview section of the fund in Sharpely as shown below.
Exit Load
On top of the expense ratio, AMCs also charge an exit load on the investment. Let's understand it in more detail. Exit load is charged when you redeem your investment. Most AMCs charge exit load if you redeem before a specific time period, while some charge exit load if you redeem more than a predefined amount.
For example, if you buy units of an equity mutual fund scheme and, for some reason, after 2-3 months you wish to withdraw your money, then you may have to pay 1% as an exit load. Exit load varies in different mutual fund schemes
While most AMCs have one year limit, some AMCs charge an exit load if the money is withdrawn before a specific period. For example, Parag Parikh Flexi Cap Fund charges a 1% exit load if the money is withdrawn before 730 days.
You can find the exit load of any mutual fund in the overview section of the fund in Sharpely as shown below.
FAQs:
What is exit load in mutual funds?
Exit load is the amount that the AMC charges if the investor withdraws money before the specified period. The percentage and time limit may change in different AMCs.
What is expense ratio in mutual funds?
The expense ratio is the amount charged by the AMC for managing our money. It is expressed in a percentage of your investment amount. If a fund charges a 1% exit load, then each year 1% of the entire investment gets deducted as fees.