How These Hidden Charges Can Reduce Your Mutual Fund Returns

May 23, 2022 Mutual Fund

Mutual funds offer a convenient way to invest in the equity and debt markets while having your funds managed by professionals. As an investor, It is critical for you to understand the fees associated with mutual fund investing.

Do you know exactly how much your mutual funds are costing you each year? Think again. It is probably a lot more than what you assume.

You should be aware that your investments with a fund house or asset management company are subject to various charges and taxes. Understanding the various fees and taxes associated with mutual funds will assist you in making well-informed investment decisions.

Most investors look at the Expense Ratio when choosing mutual funds because it is a typical measure of how expensive a fund is to purchase. However, that is not the only cost. There are other fees associated with the buying and selling of securities in the portfolio that are not included in the expense ratio.

Mutual fund fees vary in cost and purpose, and they can affect your mutual fund returns. All mutual funds have an expense ratio, which is a percentage of the total assets and is used to compensate fund managers. Other fees include commissions (or sales charges), trading fees, redemption fees, and service fees. Such expenses can make a fund two or three times costlier.

When a team of experts handles your money – stocks are bought and sold on your behalf, periodical communication is sent on investments, charges are given to the intermediaries, etc., and all these expenses come with a cost.

Although the main benefit of investing in mutual funds is that you get professional and expert money management by the fund house, they charge a fee that takes care of their compensation as well as the other investment-related expenses. So the question is, how much a mutual fund can charge?

Actively managed mutual funds generally have high fees that can be crippling to long-term results. Now widely circulated, an investment’s net expense ratio is a list of fund expenses minus brokerage costs and sales charges. The expense ratio is very important; it’s the basis for any investment decisions. But the true cost of mutual funds is usually much higher than people realise because of hidden charges.

What are the hidden charges associated with mutual fund investments?

The costs involved in mutual funds can be broadly classified into two categories:

1. One Time Charges

One-time charges are those that incur during the initial period of the investment. These are one-time fees levied as a proportion of the amount invested or withdrawn upon entering or exiting a fund. It’s also referred to as a transaction charge.

• Entry Load: When an investor has to pay a nominal charge when he purchases a fund unit for the first time, it is called an entry load. This fee supported the AMC’s distribution costs associated with promoting any mutual fund scheme.

On the other hand, the SEBI announced in 2009 that no fund house would charge an entry load to their investors. Make sure your mutual fund plan has no entry load before you invest.

• Exit load: This is a fee levied on investors when they decide to redeem their mutual fund units. AMCs impose an exit load on investors to discourage them from opting out of a mutual fund scheme prematurely. There are no fixed exit loads that are charged, and it varies based on the scheme.

The current practice is the mutual funds could charge exit load anywhere from 0.50% to 3.00%, depending on the holding period. No exit load is charged if the investors continue to hold the investment beyond the specified period. These are usually to cover distribution costs incurred by the AMC. The exit load rate varies from AMC to AMC. It is common for fund houses to charge an exit load if you redeem the mutual fund units within a year. No exit load is applied if you redeem your units after the lock-in period.

The exit load is generally computed as a percentage of the mutual fund’s NAV at the time of redemption. As a result, the amount removed will be the set percentage of your investment’s total NAV that you are redeeming. The remainder of your investment proceeds will be returned to you.

As a result, if the investor redeems their units before the set time period, the exit load kicks in, reducing the potential returns on maturity. A Systematic Investment Plan (SIP) involves an investor investing a set amount at regular periods. Every instalment is subject to the exit load.

2. Recurring Charges (Ongoing expenses)

This is the fee that the investor pays on a daily, quarterly, or annual basis. Recurring charges are generally charged for maintaining the portfolio, advising, marketing, and other expenses. It is also referred to as the periodic fee.

It costs money to run a mutual fund, and some funds have higher operating costs than others. Regardless of price, every mutual fund has an expense ratio, also known as a management charge or an operational expenditure. This ongoing charge is included in every mutual fund. Before your NAV is calculated, this fee is deducted from the fund’s total assets.

The expenses are charged on the Daily Net Assets of the specific mutual fund. The guideline rates are given by the regulator, and Mutual Funds cannot charge more than the stipulated structure. The expenses are deducted every day from the Net Assets of the fund, and NAV declared is after adjusting the expenses.

• Expense Ratio

  According to the SEBI guidelines, every AMC is allowed to charge investors an annual maintenance fee to cover its expenditures. The fund house charges a portion of your investment value in exchange for their services. This fee compensates management while also covering investment-related costs such as administration, marketing, and GST. The expense ratio varies from AMC to AMC and across mutual fund schemes.

  The expense ratio is derived by dividing the scheme's total expenses by the total assets under management (AUM). There are two types of mutual fund schemes: Direct and Regular. The direct plan pays no commission to a broker or agent because investors buy units directly from the fund company, whereas the normal plan pays a commission to an intermediary like a mutual fund distributor. So, the direct plan is likely to have a lower expense ratio than the regular plan.

  The Total Expense Ratio (TER) is the cost that an investor pays to maintain their portfolio. Because it is measured as a proportion of the entire fund asset. It has a direct impact on the returns that an investor might expect. The Total Expense Ratio usually has these components:

  – Management Fees: An investor's returns are usually influenced by the fund manager's competence and actions. The management fee is an expense charged for paying the fund manager for his services and the management of the investment. Managing a massive amount daily while striving to overcome market risks is no mean feat. As a result, the fund houses levy a fee that has been permitted by the SEBI.

  – Administrative Cost: Customer service, legal fees, and other expenditures associated with the operation of a mutual fund are all covered here. Some AMCs charge investors if they do not maintain the required minimum balance. They subtract this cost from the investor's portfolio.

  – Marketing Expense: This is the annual advertising and promotional fee. This fee is charged from investors for the marketing, printing, and mailing of the AMC, which keeps the investor informed via different marketing campaigns. The marketing and selling expense include agent commission as well.

  – GST: The expense ratio of mutual funds is inclusive of GST, and you do not have to pay for it separately. For any service provided by the fund, such as management, GST at 18% is payable.

The lower the expense ratio charged, the higher the investor’s profitability; even a 1% difference in expense ratio charged equals an equivalent difference in returns.

Mutual fund websites readily provide information on entry/exit loads and expense ratios for all mutual funds. Information can also be obtained directly from the funds. Investors should be informed of these hidden fees and charges before investing in a mutual fund scheme. Before investing in a mutual fund scheme, investors must be aware of these hidden fees and charges.

In recent years, investors have become more sensitive to the fees they’re paying to invest. Mutual fund houses are feeling the pressure to reduce their fees to better compete with ETFs, robo-advisors, and other lower-cost options.

Although mutual fund fees have decreased significantly, be cautious. High fees can deprive you of a significant portion of your portfolio’s growth over time, and studies show that higher fees do not equal better performance. As a result, excessively high costs can eat into your portfolio returns and can cost a fortune in lost profits over the long run.

This article first appeared on PersonalFN here