Buying mutual funds? Beware of costs!

The benefits of investing in mutual funds are well-known and widely touted. A major attraction held out is that investors in mutual fund get the benefit of an expert investment manager and professional management and housekeeping of records. But fund managers are also often among the highest paid corporate managers, and the establishments of fund houses are also not cheap. So, who pays for all this? Well, since there is no such thing as a free lunch, it shouldn't come as a surprise that it's the fund investors who foot these bills. Find out how much this can set you back by...

Expenses incurred by mutual funds are a critical factor because they eat into the returns which would otherwise be available to investors. Internationally, therefore, expense ratio is an important parameter when funds are compared. In India, however, this has not always been the case and it's only during the last few years that investors have begun to appreciate the significance of expense ratios.

Management fees

The investment and advisory fees that the AMC proposes to charge the mutual fund has to be disclosed in the offer document.

Schemes with loads

The regulations prescribe the following limits on the management fee that can be charged by the AMC each year:

• 1.25% on the first Rs. 100 crore of weekly average net assets of scheme;
• 1% on weekly average net assets in excess of Rs. 100 crore.

To clarify:

• The base for calculation of management fees is net assets - not unit capital. Net assets could be more than, or less than, unit capital, depending on investment performance and expenses charged to the scheme.
• The limits are prescribed with respect to the scheme. Thus, the first Rs 100 crore (Rs 1 billion) of net assets of every scheme of the fund would be entitled to the higher management fee of 1.25 per cent.
• Open-end schemes calculate their net assets every day. So management fees too are provided for on a daily basis.
• While management fees would be accrued every day or every week, the actual payment by the fund to the AMC would be at such frequency as is agreed between the two - say, quarterly. Until then, the amount would be shown in the balance sheet as a liability item - "management fees payable".

In the case of fund of funds schemes, the total expenses including the management fees shall not exceed 0.75% of its daily or weekly average net assets, depending upon whether the NAV of the scheme is calculated on daily or weekly basis.

No-load schemes

If the AMC decides not to recover load from investors, it can recover an additional 1 per cent as management fee. Thus the limits would be:

• 2.25% for the first Rs. 100 crore of weekly average net assets, and
• 2% on the remaining net assets.

The recovery of the incremental management fee is permitted only until the initial issue expenses (subject to limit of 6 per cent on resources mobilized) have been recovered.

The regulations also prescribe that the following items will be kept out of net assets for the purposes of calculating management fees:

• Investment by the AMC in the scheme;
• Investment by the scheme in other mutual fund schemes; and
• Issue expenses not written off.

Recurring expenses

In addition to the initial issue expenses and management fees, the following recurring expenses can be charged to the fund:

• Marketing and selling expenses including agents' commission;
• Brokerage and transaction cost;
• Trustees' fees;
• Registrar's charges;
• Audit fees;
• Custodian fees;
• Expenses on investor communication, account statements, dividend / redemption cheques and warrants;
• Expenses on fund transfers;
• Insurance premium paid by the fund;
• Winding up costs for terminating a fund or a scheme;
• Costs of statutory advertisements; and
• Service Tax.

Expenses other than the above, which are directly attributable to the scheme, may be charged to the scheme with the approval of the trustees and within the overall limits. However, the following cannot be charged to the scheme:

• Penalties and fines for infraction of laws;
• Interest on delayed payment to the unit holders;
• Legal, marketing, publication and other general expenses not attributable to any scheme(s);
• Expenses on investment management / general management;
• Expenses on general administration, corporate advertising and infrastructure costs; and
• Depreciation on fixed assets and software development expenses.

The regulations prescribe the following limit on recurring expenses (excluding the initial issue expenses and redemption expenses, but including management fees):

For balanced schemes, the limit would depend on whether the scheme is predominantly invested in equity or debt. Accordingly, either the equity scheme limit or the debt scheme limit would apply. Expenses above these limits cannot be charged to the investors.

As seen above, one per cent higher management fee is permissible in the case of "no load" schemes. But the management fee would need to be accommodated within the overall expense limits.

Loads

Types of loads
Deferred Load

Deferred loads are not applicable on open end schemes.

Entry load

An AMC may decide that investors should pay more than NAV for their investment in each unit of the scheme. This incremental amount paid by new investors is called "entry load", or "front end load". Thus, if a scheme has NAV of Rs. 11 and entry load of 5%, the investor would pay Rs. 11.55 for each unit:

Sale Price = NAV plus Entry Load

The entry load (Re. 0.55 in the above case) would be retained in a separate account from which the AMC would meet part of its selling and distribution expenses. Generally, debt schemes do not charge an entry load.

Exit load

An AMC may decide that sellers would recover less than NAV for the units they sell in a scheme. This shortfall, borne by existing investors, is called the "exit load" or "back end load". Thus, if a scheme has NAV of Rs. 11 and exit load of 5 per cent, the investor would receive only Rs. 10.45 for each unit redeemed.

The exit load (Re. 0.55 in this case) would go into a separate account from which the AMC would meet part of its selling and distribution expenses:

Re-purchase Price = NAV minus Exit Load

Contingent deferred sales charge (CDSC)

AMCs often choose to reward investors who stay with them longer. This is achieved through a Contingent Deferred Sales Charge, where the longer an investor holds on to her units, the lower the CDSC she bears.

For instance, there could be a load of 2 per cent if the investor exits within 1 year; the load could go down to 1 per cent if the investor exits after 1 year but within 2 years; and no load if the investor stays on for 2 years.

Load restrictions

Loads reduce the returns to the investors. Hence the need for restrictions on the load that AMCs can charge.

The regulations provide that:

• Entry load cannot be more than 7% of NAV. Therefore, for a scheme having NAV of Rs. 20, the maximum sale price is Rs. 21.40 (Rs. 20 plus 7%).
• Exit load cannot be more than 7% of NAV. Therefore, for a scheme having NAV of Rs. 20, the minimum re-purchase price is Rs. 18.60 (Rs. 20 minus 7%)
• The difference between sale price and re-purchase price cannot be more than 7%, calculated with respect to the sale price. Thus:

for a scheme of NAV Rs. 20, if the AMC would like to sell new units at Rs. 21.40, the re-purchase price cannot be lower than Rs. 19.902 (Rs. 21.40 multiplied by 93%); and

for the same scheme, if the AMC would like to re-purchase existing units at Rs. 18.60, it would need to bring the sale price for new units to a maximum of Rs. 20 (Rs. 18.60 divided by 93%).

• CDSL can only be levied if the investor redeems the units during the first four years after purchase. Also, the CDSL cannot exceed the following limits:

Load funds and no load funds

• AMCs may launch schemes either on a "load" basis or on "no load" basis or on a mixed basis (one class of units on load basis, the other class without load). In a no-load scheme, the initial issue expenses would not be charged to the scheme. In a partial load scheme, part of the initial issue expenses would not be charged to the scheme.
• There is no bar on a no-load scheme charging ongoing sale expenses to the fund.
• The attraction for AMCs is that they can recover an additional management fee of 1 per cent of NAV in the case of no-load funds. The disincentive is that the total expense limit on a sliding scale from 2.5 per cent to 1.75 per cent would apply even for a no-load scheme.
• In a no-load scheme, entry and exit load is not chargeable. Thus, sale and re-purchase of units would be at NAV. However, the AMC can levy a CDSL even in a no-load scheme.

Excerpt from: Indian Mutual Funds Handbook

Author: Sundar Sankaran

Price: Rs 395/-

Sundar Sankaran, an authority on the subject of mutual funds, has handled more than 200 seminars on the subject all over India.

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