Every financial product has a cost that is borne by the investor. There are different costs for different financial products with no standardization. Within financial products as well, there could be different costs. For e.g. when you buy insurance, the cost of buying a term plan is different from a ULIP. Within term plans also, the cost of an LIC Term plan will be different from an HDFC Term plan. Similarly, in mutual funds, the costs are different for various categories of products, and within those products also, costs will vary from mutual fund to mutual fund. Understanding & fully knowing the cost of a financial product is extremely critical to know how much you would pay which will eventually have an impact on the returns you make from that investment. In the case of mutual funds, there are different types of costs, let us understand each.
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Different Types of Costs in Mutual Funds
This is a fee you pay upfront when you invest in a mutual fund. Entry loads used to be as high as 2.25% till 2009 but were completely abolished or made zero by SEBI in 2009. This was a major cost of investing in mutual funds earlier, but it no longer exists. Imagine you investing INR 1,00,000 in a mutual fund and INR 2,250 being deducted upfront itself without any returns. This is gone now and has aided in higher returns in the hand of the investor.
This is a fee you pay if you redeem or withdraw your funds before a specified period. Different funds have varying exit loads. Generally, most open-ended equity funds have an exit load of 1% if redeemed before a year, while debt funds carry lower exit loads. Many mutual funds have zero exit load as well, so you need to check the exit load of the fund before investing and when withdrawing. To know more about exit loads you can read another post of ours-What is exit load in mutual funds and how is exit load calculated?
The expense ratio is the most important cost in a mutual fund. It is the annual fee, which is deducted each year towards management fees, fund management charges, administrative fee, brokerage and operating costs. This is the fee that the mutual fund charges for managing your money. Every mutual fund has costs such as fund management costs, branch costs, employee salary costs and operating expenses. All these are charged in totality and called an expense ratio.
It is not charged upfront or taken separately from an investor, it is adjusted in the daily NAV which is declared by the mutual fund company. Expense ratios vary according to Assets Under Management (AUM) of the fund. The higher the AUM, the lower the expense ratios. These expense ratios are decided and regulated by SEBI (Securities exchange board of India), which is the mutual fund regulator. Mutual funds cannot charge expense ratios as per their wish. They must be charged based on the parameters set by SEBI. Expense ratios range from 0.05% to 2.25% annually. You can check the expense ratio of any mutual fund scheme by visiting the mutual fund website or AMFI’s website (Association of mutual funds of India). The latest expense ratios are uploaded on these sites.
SEBI has also allowed mutual funds to charge extra 0.30% over and above the expense ratios to promote mutual fund investing in tier-2 & tier-3 cities also called the B-30 cities (beyond 30). Mutual funds are supposed to conduct investor awareness programs and can also pay higher brokerages to intermediaries in these locations to promote mutual funds.
Every investor must check the expense ratio of the mutual fund scheme before investing. The total cost basis the above works out to 0.05%-2.55% for different categories of mutual funds-equity, debt, hybrid, and gold. You should avoid investing in schemes with abnormally high expense ratios unless there is a significant difference in the returns compared to other mutual funds in the same category.