Hidden costs in mutual funds - Why MF investing is expensive ?

A mutual fund is a collection of stocks or bonds or combination of both. Such collections are sponsored and managed by asset management companies (AMC) like HDFC mutual fund or ICICI asset management company. These companies collect funds from the general public and invest the amount in a sponsored collection based on the terms and conditions agreed by individuals while making the investment decision.

AMC’s make money by charging fees on the amount individuals invest. There are different kinds of fees, mutual funds charge:

1. Expense ratio : An AMC incurs various expenses like marketing & distribution expenditure, administrative cost and research expense. All these outlays are combined together and are passed onto the investor in the form of expense ratio. Expense ratio tells you how much you pay AMCs in percentage term every year to manage your money. For example, if an investor puts in Rs 10,000 in a mutual fund with an expense ratio of 2%, then he/she is paying the fund Rs 200 every year to manage the investment. It means that if a fund earns a return of 15% and has an expense ratio of 2%, only 13% returns will be passed onto the investors. Reported NAVs are net of fees and expenses, therefore, it is necessary to know how much AMC is deducting in the form of expense ratio.
2. Transaction charges : If an investor decides to invest in the mutual fund plan through a distributor, then asset management companies also collect transaction fees from the amount that is invested in mutual funds. Rs.100 is deducted for subscriptions of more than Rs.10,000. This charge is also applicable on systematic invest plan (SIP) of Rs.10,000 or more. The transaction charge is then passed onto the distributor.
3. Exit load : Asset management companies also charge exit load when investors’ want to redeem or sell investment before predefined interval. For example, Franklin India Smaller Companies Fund charges 1% of market value of investment as exit load if redemption is within 365 days.

Transaction charges are minuscule and can be avoided by investing directly into the fund plan. Exit load is imposed to deter people from short term investment behaviour. Hence for the purpose of our analysis we will ignore these charges and only consider expense ratio that is paid by all mutual fund investors.

Suppose an investor decides to invest Rs 1 lakh for a period of 10 years in a mutual fund charging an expense ratio of 2%. Assuming the mutual fund generates a return of 10% every year for next 10 years, chart below shows how investor’s money will grow in the same period under two different scenarios – one with expense ratio and one without expense ratio.

In the scenario where mutual fund does not charge any expense ratio, investor will have approximately Rs 2.6 lakhs at the end of 10 years. In the other scenario where mutual fund charges an expense ratio of 2%, investor will have Rs 2.16 lakhs which is Rs 43,000 lower than the previous scenario. Thus, a small looking expense ratio of 2% resulted in lowering investors returns by 43% over a 10 year period.