A 1% difference can affect your investment returns drastically

Manvi Agarwal
·5-min read

I was talking to my friend, Alok, about investing in mutual funds. He was looking for a diversified equity mutual fund for his long-term goals. "I found these great mutual funds, Fund1 and Fund2. But I am confused between the two as they both have generated similar returns over long periods'', he said.

Even though he chose good funds that suit his risk and return appetite, he missed a common mistake, ignoring the cost of investing in these funds.

Impact of Mutual fund costs: How just a difference of 1% can impact your returns

Choosing a fund based entirely on returns does not always guarantee the best performance. An investor looking for an edge must also focus on seeking funds with low costs. Because much like a mutual fund's returns, the costs associated are also subject to the power of compounding.

Even though these costs seem small, over time they can balloon up, eating away at your returns.

Let's understand this better with an example:

Alok liked two funds - Fund1 and Fund2. Although both funds generate the same return of 13.8% (gross return) the value of the investment at the end of 10 years will be very different owing to the difference in the cost of the funds.

Let’s assume Alok invests Rs.1,00,000 for ten years in these two funds.

Fund1

Fund 2

Gross Return – return reported by the Mutual Fund

13.8%

13.8%

Cost of investing

1.5%

2.5%

Net Return

12.3%

11.3%

Investment Value at the end of 10years

Rs 3,39,987

Rs 3,07,933

Had Alok invested in Fund1 he would have made almost 10% more than Fund2.

Now, we are not condoning that you must always opt for a low-cost fund. All we are saying is that you cannot look at a fund's returns in isolation to judge its performance. You must factor in the costs as well.

In this example, even though Fund D charges more (higher expense ratio), it generates a much superior gross return. And so, Alok is better off investing in a high-cost fund as the net return (Gross Return – Expense Ratio) is higher.

Alok also invests in 2 other funds

Fund C

Fund D

Gross Return – return reported by the Mutual Fund

12.8%

14.5%

Expense Ratio (Fee)

1.5%

2.4%

Net Return

11.3%

12.1%

Investment Value at the end of 10years

Rs 3,07,933

Rs 3,33,322

Since the costs associated with running a fund are charged directly to the investor, they are a direct hit to the returns. So, if a fund generates an annual return of 13% and your cost of investing is around 2%, your net return equals 11% (13%-2%).

So anytime you want to judge the performance of a fund, focus on the net return of 11% (net return = gross return-expense ratio – any other expenses) and not the gross return of 13%.

Primary costs associated with investing in mutual funds

Although SEBI (Securities and Exchange Board of India) banned Mutual Funds from charging Entry loads in 2009 there are various types of costs still associated with investing in Mutual funds:

  1. Expense ratio: Simply put, it is the cost of running a mutual fund paid by the investor. A Mutual fund (Asset Management Company), much like any other company, incurs various types of operating expenses.
    The most significant cost head is the Fund manager’s salary. Other expenses include the distributor’s commission for selling the fund, company auditors fee, personnel costs etc. Mutual Funds pass on these costs to investors, in the form of a fee, often referred to as the ‘expense ratio’. Expressed in the form of a percentage it ranges from 1-2.5% of the total investment value and is published in the fund’s prospectus.

  2. Exit load: Mutual Funds prefer long term investors. To ward off short-term investors, they set a period of around 1-2 years. So, if you were to withdraw your investment before this period, you will be liable to pay a penalty fee, referred to as the exit load.
    Also calculated as a % to the total investment value, it usually varies from 1-2%.

  3. Other One-time transaction costs: Some funds levy a small one-time transaction fee for new investors.

SEBI has set a limit on the fees (expense ratio) that the Mutual Funds can charge its investor. As directed by SEBI, Equity Mutual funds are allowed to charge up to 2.5% and debt funds up to 2.25%, whereas, ETF & Index funds can charge only up to 1.5%.

Mutual Fund fees (expense ratio) vary widely from fund to fund. Actively managed funds usually charge higher fees to compensate the managers for their expertise. Whereas, passively managed mutual funds, like the ETF and Index funds whose main focus is to mimic the returns of an index, charge a lot less.

Mutual Fund Fees (expense ratio) Limit set by SEBI

Equity Mutual funds

2.5%

ETF & Index fund

1.5%

Debt Mutual Funds

2.25%

Little things like costs can have a significant impact on your returns over the long-term. It can improve them considerably, getting you closer to your financial dreams.

Although a fund's long-term returns and costs are an excellent judge of its performance, ultimately, your choice of a fund should be a function of your risk-return expectations. It is the sole determinant that will ensure you are on track to achieving your long-term goals.

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