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%