Mutual fund expense ratios and commissions - know them; minimise them

Saturday, February 13, 2016 Swati Aggarwal 0 Comments

1. Expense ratios are the most important costs of investing in mutual fund since they are deducted every year and are unavoidable

2. Investors can easily reduce their expense ratio and increase returns by buying direct plans of mutual funds through providers such as ORO

The different type of expenses

There are mainly two kinds of expenses that are associated with investing in mutual funds. The first kind of costs is explicitly paid by the investor. These include:

1.Entry load/ Transaction charges: Entry loads are paid when investors enters the mutual fund. They are typically specified as a percentage of the investment amount. However since 2009, SEBI has banned entry loads. Instead transaction charges have been introduced where the mutual fund company can choose to charge investors either Rs 150 ( for first time investors) or Rs 100 ( for existing investors) when they buy a fund.

2.Exit loads: Exit loads are paid when an investor exits the fund before a pre-defined interval and are also specified as a percentage of the investment amount. The lock-in period is typically between 1 to 2 years and the load is usually around 1%. However this varies with the liquidity of the fund with liquid funds having lesser lock-ins and lower exit loads.

While the above costs are explicit there are another set of costs which are paid by the investors implicitly through the NAV. This is the expense ratio.

Expense ratio: The single most important number which summarises the cost of investing is a mutual fund is the expense ratio. While entry and exit loads are one time and avoidable, the expense ratio shows in percentage terms how much you are paying the fund every year to manage your money. For instance, if the expense ratio of a fund is 2% p.a. and you have invested Rs. 1,00,000 in that fund, then that means that you pay Rs. 2000 every year to the fund to cover expenses.
Expense ratios range from c. 0.1% – 2.5% and vary considerable across funds: Equity funds are more expensive than debt funds; active funds are more expensive than index funds. Also larger fund typically have lower expense ratio since fixed costs can be spread over more assets.

Expense ratio is included in the NAV

To understand how the expense ratio is incorporated in the NAV, consider the following example for a fund which has an expense ratio of 2% per year. Suppose the NAV of the fund at the beginning of the year is 100 and it has a pre cost returns of 12% during the year then after deducting the expense ratio, the post cost returns of the fund will be 10%. The end of the year NAV would be reported as100*(1+10%) = 110 and not as 112. In money terms, if an investor had invested Rs 1,00,000 at the start of the year, that would be worth Rs. 1,10,000 at the end of the year instead of Rs. 1,12,000. The difference of Rs. 2000 (or 2% of 1,00,000) going towards expenses.

Agent commissions are included the expense ratio but are avoidable

While the expense ratio includes multiple cost heads, one cost head which is particularly important are the agent commissions. 90% retail investor buy mutual funds through agents – this could be your neighbourhood distributor or even the various online platforms. While agents often market their services as “free” to investors, in reality they charge the mutual fund company for selling their products. This cost is then eventually borne by the investor because the commissions are included in the expense ratio.

There are two types of commissions that investors “pay” to their agents:

1.Upfront commissions: These commissions are paid one time (as a % of the investment amount) at the time the investor makes his or her investment. 

2.Trail commissions: Trail commissions are paid every year as long as you continue holding your investments in the fund. These are again paid out as a percentage of the investment amount.
It is important to be aware of these commissions because they can form as much as 50% of the expense ratio and are totally avoidable!

One simple way to reduce your expense ratio

In 2013, SEBI has mandated that there is no reason why every investor should be forced to pay agent commissions. If an investor goes directly to the mutual fund company to buy a fund, so that no agent is involved then they should be able to get the same fund cheaper. As a result since 2013, every mutual fund scheme has two plans: the regular plan and the direct plan. These two are similar in all respects except that the direct plan has a lower expense ratio because no commissions are involved. Figure 1 shows the difference in expense ratio between regular and direct plans for common types of mutual funds

Figure 1: Average expense ratios of different kinds of mutual funds 
Source: ORO Wealth

As the Figure shows, commissions form a substantial part of the expense ratio of standard plans. By going direct, investor can get expense ratios which are 30%-50% lower. Given the power of compounding, these differences in costs can make a big difference to your returns over the investment horizon. To find out more about direct plans and how much you can save with them, check out our article Invest in direct mutual funds for higher returns. You can also check the interactive graph on our home page

To conclude, it is difficult to evaluate different mutual funds based on their costs alone. A fund maybe more expensive but it may also generate better returns more than making up for the higher costs. But to buy the same mutual fund at higher costs is like leaving money on the table. Stop doing that with you hard earned money today. Start buying direct funds, start buying with ORO.

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