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What is the Cost of Funds?
April 21, 2009

For a person investing in mutual funds for the first time, the huge amount of financial jargon can be overwhelming. In this article, we explain one of the common issues investors would ask themselves: the cost of investing in funds.


Author : iFAST Research Team



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For a person investing in mutual funds for the first time, the huge amount of financial jargon can be confusing and overwhelming. Frequently, financial terms are abbreviated or shortened when used in discussions, leaving newcomers lost in a world of meaningless terms and phrases. One of the frequently asked questions newbie investors would surely have asked themselves when they stepped into the world of mutual fund investing is: what is the cost of investing? This article aims to shed light on this question.

Expense ratio

The first term that new investors should know is the fund’s expense ratio, which refers to the various expenses that the fund incurs to keep it running, expressed on an annual basis, and as a percentage of the fund's net asset value (NAV). For example, if a fund incurs Rs. 15 lacs in expenses over one year, and the fund has a net asset value of Rs. 10 Crore, then the fund has an expense ratio of (15/1000) or 1.5%. Typically, a large part of a fund's expense ratio will consist of its annual management fees, with the rest of the fund’s expense ratio consisting of trustee fees, administration fees, accounting and valuation fees, custodian fees, registrar fees, legal and professional fees, printing and distribution costs, audit fees, amortised expenses and other expenses. Depending on the fund house, the expense ratio generally range from 0.5% of NAV for bond funds to 1.5% or higher of NAV for equity funds. In a situation where the expense ratio of the fund is not known, it might possibly be found by looking through the annual fund report. As a general rule, the expense ratio will at least be equal to or higher than the annual management fees.

An expense ratio does have an impact on fund returns. For example, if a fund's assets had risen 10% over the past year, and it has an expense ratio of 3%, the fund's returns after expenses would be 7%. In the other words, if a fund had returned 20% over the last one year, then in actual fact, the fund's assets actually might have risen by 23%, as the 20% return reported had already taken into account the fund's expenses. However, the fund’s price does not suddenly decline at the end of the year by the amount of the expense ratio - it is instead deducted daily on an accrued basis.

If you see a fund with a huge expense ratio like 4% or higher, you have to be careful as most of the actively managed funds in the industry have expense ratios of between 1.6% to 2.5%, and such a fund would have to outperform its peers by more than the difference in their expense ratios each year just to achieve an equivalent return after expenses. As a general rule of thumb, any equity fund with an expense ratio of over 3% should bear close scrutiny to monitor its worth – most funds have expense ratios ranging from 1.6% to 2.5%.

At this point in time, one may conclude that it would be best to look for funds with the lowest expense ratios. However, having a very low expense ratio does not guarantee good performance. There are some funds with very low expense ratios that are hardly the best performers in their peer group and there are some funds with slightly higher expense ratios that achieve a net performance much better than their peers. So while expense ratios are important, they are only one of the factors that would determine a fund's returns. Some good funds are worth a slightly higher expense ratio because their actual performances are far better than their peers. For that reason, investors should look at the whole picture rather than just one number, when they examine expense ratios.

Entry Load

The second term that investors should look at is the entry load. This is a commission or sales fee charged at the time of the initial purchase for an investment. It is deducted from the investment amount and this lowers the size of the investment. For mutual funds, the use of loads prevents frequent trading of the fund, which can hurt a fund if it has to hold large cash reserves to meet payouts. Loads are added to the NAV of fund units when the sale price is calculated.

Exit load

The last term that investors should look at is the exit load, a fee that an investor pays when selling a mutual fund within a period of time. The fee is shown as a percentage and different funds will usually have different options available to the investors pertaining to how they want the exit load to be applied.

conclusion

We hope that investors will look at the whole picture, and not just the expense ratios, when assessing funds. With a better understanding of the various costs involved in the investing process, investors can now step confidently into the world of mutual fund investments.

Table 1: Fund Costs

Cost / Fee

Key points

Expense ratio

  • Refers to the various expenses that the fund incurs to keep it running, expressed on an annual basis and as a percentage of the fund's net asset value
  • General rule: expense ratio will at least be equal to or higher than the annual management fees
  • Investors should look at the whole picture and not just expense ratios when assessing funds

Entry Load

  • A commission or sales fee charged at the time of the initial purchase for an investment
  • Deducted from the investment amount and lowers the size of the investment

Exit load

  • A fee that an investor pays when selling a mutual fund within a certain number of days
  • Fee is shown as a percentage and different funds will usually have different options pertaining to application of exit load
Source: iFast Compilations



iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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