Do expenses really matter?

Do expenses really matter?

Having discussed the various costs and expenses involved while investing in a mutual fund scheme, let’s now find out if they really matter. To understand this better, we shall compare two mutual fund schemes, one with a low cost structure (say Fund A) and the other which isn’t quite as charitable (say Fund B). Investments in Fund A attract an entry load of 1.0%, while the number is 2.5% for Fund B. Similarly, the recurring expenses are 1.5% and 2.5% for fund A and fund B respectively. Assume that Rs 100,000 (one-time investment) is invested in each fund for a 10-Yr period and that both the investments grow at 15.0% per annum.

Fund A vs............... Fund B
................................Fund A ........Fund B
...........Entry load................ 1.00% ............2.50%
Recurring expenses............ 1.50% ..............2.50%
Amount invested ........(Rs) 100,000.......100,000
Growth rate (per annum)...... 15.00% ............15.00%
Maturity amount 10 yr (Rs) ...344,331 ........306,217

On maturity (i.e. at the end of 10 years), the investment in fund A would be worth Rs 344, 331, while that in fund B would be worth Rs 306, 217. The differential can be traced to Fund A’s cost effectiveness.

While evaluating a mutual fund scheme, factors like the AMC’s investment philosophy and style, track record across parameters (risk and return) are usually given due weightage. To that list, investors would do well to add the fund’s cost efficiency. After all, as we have observed, over the long-term the costs involved can have a significant impact on the fund’s performance.

Stock market still trading 25-30% higher

In the high-flying world of equities, it’s seldom that investors talk about dividends. This is surprising; given that one of the best things about investing in a well-managed company is that it provides investors with regular tax-free dividend income that also grows along with the company.

In fact, for purists, the truest form of investment is the one that is done for dividends. Everything else is speculation, with varied time frames.

But do dividends teach us any lesson, given the current meltdown? And do they help in our efforts to find the bottom? An ETIGanalysis suggests that the answer to both these questions may lie in the history of dividend payouts of listed companies rather than their forward-earning estimates, as many traditionalists will like to believe.

A historical trend line of the dividend paid out by Nifty companies offers interesting insights — the current bull run began in April ’03 at an all-time high dividend yield of about 3.2% and the correction in January ’08 began at a seven-year low Nifty dividend yield of 0.8%.

Even more interesting is the fact that over the long term, there seems to be a close correlation between the growth in the dividend payout and the movement in the Nifty. To find this out, we indexed Nifty and the dividend-payout of Nifty stocks, beginning January 1999.

As the chart shows, whenever the Nifty has shot past and stayed above this dividend trend line for a sustained period, a correction has followed. And greater the gap, the sharper has been the ensuing correction. This phenomenon was first observed during the May ’04 correction and then, in May ’06.

Interestingly, just prior to that crash, Nifty had overshot its par value by close to 50%. What is striking, however, is that the Nifty started its recovery the very day the two trend lines converged. Even though the Nifty nearly doubled its value from its June ’06 lows over the next 18 months, dividend payments grew by less than 1/6th the rise in Nifty.

No wonder, the gap between these two trend lines had assumed dangerous proportions by January ’08, with the Nifty overshooting its fair value by over 100%! What followed was for every one to see. What’s even scarier is that the gap between these two trend lines continues to be what the gap was at the beginning of the May ’06 correction!

This means that to close the gap, either the Nifty has to fall by another 25-30% or India Inc’s dividend payout has to grow proportionally. With the latter looking unlikely, we seemed to be destined for an extended, painful and bloody bear market.

Mutual Funds: Cost to investor

The utility that mutual funds can offer to investors has been discussed and often eulogised in great detail. However, there is another vital aspect to mutual funds that is rarely spoken about – the costs. Investing in mutual funds entails bearing certain costs on the investor’s part. These costs, in turn have an impact on the returns clocked by the investor. In this article, we take a closer look at the various costs and expenses borne by investors while investing in a mutual fund scheme.

1. One-time charges
Entry/exit loads and initial issue expenses qualify as one-time charges, as opposed to recurring expenses which have been dealt with later in the article. First, let’s consider the case of new fund offers (NFOs). Over the last few years, investors have been faced with a deluge of NFOs. But in recent times, a perceptible trend in NFOs has been a rise in the number of close-ended funds. This phenomenon can be traced to the rules governing initial issue expenses. Close-ended funds are not permitted to charge any entry load; instead 6% of the sum mobilised during the NFO period can be utilised to meet the initial issue expenses. The same can be amortised (charged to the fund) over the fund’s close-ended tenure.

For example, if a close-ended fund were to mobilise Rs 5 billion (Rs 500 crores) during the NFO period, the asset management company (AMC) can utilise Rs 300 million (Rs 30 crores) to meet the sales, marketing and distribution expenses. Furthermore, the stated sum will be charged to the fund. This will impact the returns clocked by the fund. Any amount over the stated 6% has to be borne by the AMC.

Conversely, in the case of open-ended NFOs, funds are required to meet all the sales, marketing and distribution expenses from the entry load. They are not permitted to charge any initial issue expenses. The rules governing entry/exit loads state that taken together, the two cannot account for more than 6% of the net asset value (NAV). Charging an entry load for the entire 6% upfront would adversely affect the fund’s performance in the initial period. Hence AMCs choose to have rather “rational” entry loads in the range of 2.25%-2.50%. Like initial issue expenses, entry loads also eat into the investor’s returns, since the investor has that much less money working for him.

For example, say an investor invests Rs 5,000 in an open-ended fund that charges an entry load of 2.50%. Effectively, only Rs 4,875 is invested in the fund.

It is not difficult to understand why AMCs have a newfound liking for close-ended funds. With the provision for charging 6% of amount mobilised towards initial issue expenses, AMCs are better equipped to compensate the distributors and agents, who in turn help the fund houses in accumulating more assets. Higher assets translate into higher revenues for the AMCs. Of course, close-ended funds do offer advantages as well. For example, the fund manager can make investments from a long-term perspective and investors are given the opportunity to invest for a pre-defined investment horizon. However, investors would do well to factor in the costs involved.


2. Recurring expenses
Investors also have to contend with recurring expenses, which are charged annually to the fund. These expenses are revealed in the form of an expense ratio that is declared twice a year. Recurring expenses (as is the case with amortised initial issue expenses) are “silent” in nature since they don’t necessarily attract the investor’s attention. The reason being that the fund’s NAV is declared after the recurring expenses have been accounted for.

The Securities and Exchange Board of India (SEBI) has laid out guidelines defining the manner in which recurring expenses can be charged; the same is a factor of the fund’s average weekly assets (however most AMCs choose to compute it as a percentage of the average daily assets).

The expense ratio
Average daily net assets........% Limit

First Rs 1,000 m............2.50%
Next Rs 3,000 m............2.25%
Next Rs 3,000 m............2.00%

On balance assets...........1.75%

As can be seen from the table above, the grid for recurring expenses has been structured in a manner to ensure that the expenses charged to the fund reduce with an increase in the asset size. The recurring expenses include marketing and selling expenses (including agents’ commission), brokerage and transaction costs, custodian fees and fund management expenses (paid to the AMC), among other expenses. A typical list of recurring expenses for an equity fund would look like the following:

Recurring expenses for an equity fund
Expenses.........................% Of average daily net assets
Fund Management..................................................1.25%
Marketing & Selling................................................0.50%
Custodian Fees........................................................0.25%
Investor Communication.......................................0.20%
Registrar Fees..........................................................0.15%
Trustee & Audit Fees..............................................0.15%
Total Recurring Expenses..................................... 2.50%

The expense head which merits attention is “fund management”; this represents the AMC’s revenue stream. In other words, the salaries and other compensation offered to the fund management team is charged to the mutual fund scheme under this head. SEBI guidelines explicitly state the manner for computing fund management charges and limits for the same.

Fund management expenses
Average daily net assets............... Limit
First Rs 1,000 m................................1.25%
On balance assets..............................1.00%

Don't exit SIPs in a falling market

Joydeep Ghosh

Sunil Shah is a worried man today. He entered the market in October 2007, when the Sensex was rising by 1,000 points in a single week.

At that time, his already-invested friends advised him to enter the market through systematic investment plans of mutual funds. Since he had never invested in the markets before, he decided to go the whole hog and started four SIPs of Rs 5,000 each.

In the last eight months, he has invested Rs 160,000. However, the erosion in the net asset value of his mutual funds has meant that the value of his invested money has dropped to Rs 120,000. He does not know if continuing with the SIPs makes any sense now.

"In such cases, investors call up to stop their SIPs or exit them. But, we try to convince them as much as possible to the contrary," says a financial planner. And this Monday, when the Sensex slipped by 506 points, Shah did the same. He called his mutual fund distributor to stop his SIPs.

The distributor told him that it does not make sense to do so as he was getting more units of the same fund for the same money.

"So what? My portfolio is already down 25 per cent. This is like throwing good money after bad money," Shah argued.

His fund advisor explained, "When the NAV falls, you are going to get more units of the fund. That means when the market turns around, you will get much more returns."

Suppose the NAV of a fund is Rs 20. When you invest Rs 5,000 in that fund, the total number of units purchased would be 250 (Without considering 2.25 per cent entry load and an annual 2 per cent fund management charge in equity funds).

However, there is no entry load on investors if they approach the asset management company directly.

Now, if the NAV falls to Rs 18, the number of units that can be purchased is 277.7. A further fall to Rs 15 and the number of units in the kitty is 333.3. Let us take Shah's case. If he were to continue his SIPs, the numbers could look something like this.

Suppose, he accumulated 1,500 units in the first six months at the NAV of Rs 20, another 1110.8 for four months at Rs 18 and another 1333.2 units for another four months at Rs 15, the total number of units he got is 3,944.

If the markets were to turn around in, say, six months and the NAV was to rise to Rs 25, his portfolio would be worth Rs 98,600 (on an investment of Rs 70,000).

And the additional 444 units accumulated during the falling market have added Rs 11,100 to the corpus.

Moral of the story: It's a good idea to continue your SIPs in a falling market.