Mutual Funds: The Costly Affair (5-6 min read)

Oscar Wilde said,

“A cynic is someone who knows the cost of everything but the value of nothing.”

But does it apply to the mutual fund industry as well?

Let’s find out…

If you are currently investing in mutual funds or ever plan to do so in future, then this article is definitely for you. It won’t take much time and even if you think you know everything about it, just read to find out what you might be missing out on and if it happens that you did know it all then I am sorry for wasting your 5 minutes…

Let’s not beat around the bush anymore and come to the point: –

People are generally told this thing, “Higher the risk, higher the return.” It’s a significant saying in life, and I too agree with it, but wait a minute; What if I tell you that the statement loses its meaning when it enters through the doors of the mutual fund industry?

Confused? Well, it’s just a matter of cost. Now you may ask, “How so?”.

Let’s take 2 funds and assume an initial investment of 10,000 bucks. Here are theirreturns: –

Type Gross return Cost Realized return 1 year return 10-year return 25-year return
High Cost Fund 12% 1.2% 10.8% 1080 17,886 1,19,865
Low Cost Fund 12% 0.05% 11.5% 1150 19,700 1,42,010

 

Choosing a low-cost fund gives you 6.5% more money in 1 year, 10% more money in 10 years and 18.5% more money in 25 years. Isn’t that a lot of money that you might be losing out on?

And therefore, I say, it’s probably the only type of investment where you can simply choose to increase your returns by minimizing the cost and keeping the risk constant as before. Moreover, just choosing a low-cost fund gives you an added advantage and a cushion to your money in hard times.

Now let’s dig deeper…have you ever played poker? No, I was not drunk while writing this article! When you play poker, you must pay the price of the table irrespective of your bet. Why did I bring poker in between? It will be clear in a second or two.

Let’s break down this COST term.

  • TRANSACTION COST.

This cost is fixed by the regulator & is fixed at Rs.100 if you have an SIP commitment of more than 10,000 bucks, and 0 if less than 10,000 bucks. (w.r.t India)

Still can’t find the relation between this and poker? Everyone must pay the price of the table irrespective of the bet they make.

Now let’s take an example, Mr. A makes an yearly SIP of 10,000 bucks in a mutual fund and Mr. B makes an yearly SIP of 50,000 bucks in the same mutual fund. Now, say suppose they earned 12% returns. After 1 year: –

Mr. A – 1200 on an investment of 10,100 {a return of 11.88%}

Mr. B –  6000 on an investment of 50100 {a return of 11.98%}

This difference of 0.1% is the price of playing poker with different amounts. The difference in the amount of your SIP makes a difference in your net returns. And this gap of returns will increase when you raise the amount of your investment or your bet in poker!

  • Now we come to the expense ratios which are the operating charges of the mutual funds.

It covers the management fees, book-keeping fees, administrative expenses, or any other operating cost that is incurred by the fund. It is very important to know the expense ratios before investing in a fund. For example, if your scheme has an expense charge of 2% and a return of 10%, the shareholder’s net return will only be 8%.

*The SEBI regulations command all the fund houses to clearly specify the mutual fund expenses and the total expense ratio structure. Also, the structure of the expense ratio is stipulated by the regulator.

* The larger the fund the lesser is the expense ratio.

3) Now this is an interesting part, there is another type of cost which is often ignored nonetheless it is important and should be considered while analyzing a scheme.

Some experts call it the INVISIBLE COST, as the fund houses don’t specify this cost in the prospectus, but it is extremely important from the point of view of the investors.

You see, when you invest in shares on your own, you must pay some brokerage and taxes (which is your trading cost), now whatever you earn would be netted out i.e.  [your gross earnings –(minus) your trading cost].

(You pay when you buy shares and you pay when you sell shares, you might earn or you might not earn but your broker earns every-time!)

Fund houses also pay the brokerage and the taxes and hence it is very important for the investor to know how much the management paid as brokerage and tax as these costs are highly related to the returns that you earn. They might pay lesser brokerage rate than you as it is negotiable, keeping in mind the volume of the trades done, but it sure is a hefty absolute amount. Hence, this becomes an important factor while choosing the right mutual fund.

(It is evident from the historical data that the more you transact, the lesser your chances of making profits. So, high brokerage may suggest higher trading i.e. lesser long-term profits although this is another story…)

Now, an important question prevails i.e. how can we find this cost?

The fund houses don’t show it directly in their prospectus, but what you can really find out is the turnover mentioned in the prospectus. (Turnover is defined as the lesser of purchase or sales of portfolio investments as a percentage of average fund assets, for example, if a fund has 300crs. of net assets and it purchased 100crs. worth of shares and sold 100crs. worth of shares, then its turnover would be 33.33%.)

Now, if we assume that the brokerage is 0.7% (i.e. 0.007). Then, we can find out the total transaction cost by simply multiplying the turnover amount by 2 and then multiplying that figure by 0.7%. This cost can be converted into a percentage of net assets.

(In our above example, the turnover amount is 100crs. so we multiply it by 2 i.e. 200crs. and then find out 0.7% of 200crs. which will be 1.4cr. = 0.46% i.e. 0.0046 o f300crs)

By this means you can compare different funds. (It is suggested that you compare the funds atleast for their past 3 years of transactions costs).

Perhaps, Oscar Wilde’s definition of a cynic doesn’t fit here, it might be because he was not aware of the mutual funds at that time (No offence). Let us all try to be a cynic for once because in the mutual fund industry, a person who knows the cost of everything also knows the true value of everything.

In the end, I would just like to say that:

“Ignoring the cost aspect of the mutual funds is like ignoring the “BEWARE OF DOGS” sign, while entering a stranger’s house.”

Obviously, it will result in pain and suffering, be it in terms of injections or loss of money. 😛

Hope you enjoyed reading it. All suggestions are welcome. Do post them in the comments section below.

P.S.- If you want to know different ways to put your money in mutual funds in India, Check out Anshul kukreti’s answer on how a common man can invest in mutual funds on Quora. 

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Powered by WordPress.com.

Up ↑

%d bloggers like this: