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Saturday, August 18, 2012

Know more about Mutual Funds and their hidden costs

What are Mutual Funds
An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Mutual funds are operated by money managers (mostly on a chargeable basis), who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Are they part of your Portfolio
If you are new to your journey towards financial freedom, you may be having some inhibitions
wrt investing directly in a company's stock. If that is the case, Mutual Funds provide you with a safe mechanism to invest in the equity market and not worry too much about buying and selling at the right time. All this is taken care of by the Mutual Fund Manager, who charges you with certain charges as a % of your total investment in mutual funds.Let us look at what charges are usually deducted from your MF account

What is Entry Load and Exit Load
Some Asset Management Companies (AMCs) have sales charges, or loads, on their funds (entry load and/or exit load) to compensate for distribution costs. Funds that can be purchased without a sales charge are called no-load funds. Entry load is charged at the time an investor purchases the units of a scheme. The entry load percentage is added to the prevailing NAV at the time of allotment of units. Exit load is charged at the time of redeeming (or transferring an investment between schemes). The exit load percentage is deducted from the NAV at the time of redemption (or transfer between schemes). This amount goes to the Asset Management Company and not into the pool of funds of the scheme. You can easily decipher the entry and exit loads from the account statement that you receive from the Mutual Fund company.

What is Expense Ratio
Here comes the tricky one. The expense ratio measures the per unit cost of managing a fund. It is calculated by dividing the fund's total expenses by its assets under management. Asset management companies (AMCs) employ highly qualified professionals to track developments in equity, debt and money markets and then transact accordingly in the asset markets to attain the objectives that are stated in the fund's offer documents. For such specialised services, the AMC pays a management fee to the professionals.
There are operating expenses too, such as the fee for transfer and registrar agents. They are responsible for issuing and redeeming units of the mutual fund and providing other related services, such as preparation of transfer documents and updating investor records. Other than these charges, a fee is also paid to the custodian, who buys and sells securities in large volumes. Moreover, there are legal expenses, audit fees, as well as marketing and distribution expenses.
A mutual fund recovers such costs through its unit holders on a daily basis. The daily net asset values (NAVs) of a fund scheme are reported after deducting such expenses which means that most of us would not even know how much is the expense ratio for the company that is being deducted

You’ve found a no-load fund so that means you’re all set, right? Not so fast. Loads are only one of the fees to look out for. While not all funds have loads, all funds do have expenses. These expenses are expressed in the form of an expense ratio. This makes it easy to compare apples to apples when looking at multiple funds since the fee is shown as a percentage.
Unlike a front load you don’t see this expense deducted directly from your account. Instead, the expenses are built into the fund’s overall return. So if you pull up your account statement and it shows that your fund had a 4.3% return, that is your net return after expenses already. You won’t have a quarterly or annual fee deducted from your account. That’s why these expenses can be tricky because they are almost hidden and people don’t really consider the effect they have on returns.

What should you look at?
So, make sure that you look at both the Entry / Exit load prescribed in the Mutual Fund document and you’re also looking at a fund’s expense ratio before making an investment. The lower the expense the better. If you’re looking for the absolute lowest fees you should probably stick to index funds. Since these aren’t actively managed and simply track an index they can keep costs down. This means you’re looking at usually only 0.10-0.25% expense ratios on index funds. Once you get into actively managed funds it’s a different story. You might find one fund charging 0.3% and another charging 1.3%, which can make a huge difference on your corpus target

The book "From Rat Race to Financial Freedom" will go in depth in the Mutual Fund world and guide you on how to invest in this asset class, when and how much to invest - depending upon the stage of Financial Freedom you have reached.

Keep investing

Cheers

Manoj Arora

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