Money Plants

Monday, February 06, 2006

MF fees: There are no free lunches

In the last post, we looked at how a mutual fund works, what an NAV means and how one can make a profit or loss.

While our illustration had just 5 investors, in the real world, there are thousands of them who entrust their money with mutual fund houses. MFs mop up money from investors and go about investing the same in equity shares. Of course, I am referring only to equity mutual funds here. If they make profits, they share the profits with investors. In case of losses too, investors have to bear them.

And like I said in the headline, there are no free lunches. A mutual fund manager is using his expertise to make money for you. So he surely needs to be compensated. There are 2 main types of compensations. One is the 'load' and second is the 'asset management charge or AMC'.

A load is a charge that the fund house levies on your investment amount as administration charges. There are 2 types of loads - entry loads and exit loads.

An entry load is a charge that is levied at the time of making the investment. Presently, this load is around 2% of invested amount. So for instance, suppose you invest Rs 10,000 in an equity mutual fund, the fund house will deduct 2%, that is Rs 200 as charges and invest the remaining Rs 9,800 in shares. The fee of Rs 200 is used to cover costs of documentation and processing your investment, commission to your agent, sending you regular updates of NAVs and portfolio allocations and so on. So your actual investment is Rs 9,800. Entry loads apply for all mutual fund schemes.

Exit load is the charge that is levied at the time of exiting from the fund. These loads are levied in case of schemes that have a minimum lock-in period. For example, the ELSS tax saving scheme. Here the minimum lock-in is 3 years. If you withdraw before completion of 3 years, you will have to pay an exit load on the amount you withdraw. The exit load varies between 2-6%.

Asset Management Charge:
This charge is levied as a percentage of the fund value. This is the charge for asset management, that is for compensating the fund manager for his portfolio management skills. This charge is around 2% per annum of the fund value and is adjusted in the daily NAV. Expenses are important and have a bearing on your return. Although a 2% fee may appear small, it is nevertheless significant.

You may have read about expense ratios of various MF schemes. An expense ratio is nothing but the impact of both the above charges on your returns.

There is another catch about expenses that you need to be wary of. When new schemes are launched (called as MF New Fund Offers-NFOs), fund houses advertise saying there is no entry load during the initial offer period. If you think thats a great bargain, then you ought to be warned. There is a devious accounting practice involved here. According to that, MFs are allowed to spread over the initial expenses in a NFO over a period of 5 years. So while there maybe no entry load, there will be an 'initial expense' that will be deducted from your NAV over the next 5 years. And this initial expense can be as high as 6% because companies tend to spend huge amounts on advertising and distributing new offers.

Coming up:
Returns on MFs-Growth, dividends or dividend reinvestments


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