There are two things that are a part of your mutual fund costs. One is the expense ratio and the other is the stamp duty. While the former is not directly debited from your investment, the latter is debited at the time of purchase. Here are all the details you need.
All mutual funds and exchange-traded funds (ETFs) charge their unitholders money for managing the funds. Annual fund operating expenses are charged as expense ratio of the fund. Expense ratio is per unit cost of managing the fund. The formula for expense ratio is the fund’s total expenses divided by its assets under management (AUM). For instance, an annual expense ratio of 1% means that each year 1% of the fund’s total assets are being used to manage the fund.
Investors don’t need to pay the amount of expense ratio upfront. The amount will be adjusted against the Net Asset Value (NAV) of the fund. Also, you do not need to calculate the expense ratio of a mutual fund. Every fund house publishes the ratios for all its mutual funds in the fund factsheets that are updated every month. The factsheets are available on the websites of fund houses.
Why the fee? The fund manager works for the fund along with a team of stock market experts, trading analysts and other knowledgeable people. The fund incurs costs for these people, apart from trading costs, auditor and advisor fees and costs needed to advertise the fund. All these expenses are to maximize returns from the fund and for managing the risks of the fund.
Which funds will have higher expense ratio? There is a direct relationship between the AUM of the fund and its expense ratio. If the AUM of the fund is small, then the expense ratio might be high. This is because the fund must meet its expenses from an asset base that is insignificant/less. However, if the net assets of the fund are significant, then the expense ratio will be much lower. This is because the expenses get shared across a wider asset base.
Apart from this, expense ratio is a key differentiator for actively managed and passively managed funds. In case of actively managed equity funds, the fund manager does a lot of work for generating the returns of the fund. The alpha or the additional returns generated is a compelling reason for the expense ratio they charge. Since passive funds don’t need much expertise or trading, the expense ratio of these funds is much lesser.
Why is the expense ratio of a fund important? This is because it reduces the returns that your fund provides, and, therefore, the value of your investment.
Is there a limit to the amount of expense ratio that a fund house can charge? On 18 September 2018, the Securities Exchange Board of India (SEBI) reduced the total expense ratio (TER) of the mutual funds while making them account for the commission to the distributors.
All expenses incurred by a fund house will have to be within the limits specified under Regulation 52 of SEBI Mutual Fund Regulations. For actively managed equity funds, the TER allowed is 2.5% for the first Rs. 100 crores of the average weekly net assets. It will be 2.25% for the next Rs. 300 crores, 2% for the subsequent Rs. 300 crores and 1.75% for the balance AUM. For debt funds, the expense ratio will have to be 0.25% lower than that allowed for equity funds.
Should you choose funds based on expense ratio? While expense ratio is important, it should not be the only criterion while selecting funds. Why? A scheme with a consistent track record providing high returns might have a higher expense ratio while one with a lower expense ratio gives poor returns. So, fund performance is more important when compared to expense ratio for equity funds,
For debt funds, expense ratios might be important. Debt funds provide around 5-9 per cent. Since the yield is low, every rupee will count. As expenses are deducted from the fund before calculating the NAV, a lower expense ratio for debt funds could mean higher returns.
The government has imposed a stamp duty on the purchase of mutual funds. This is with effect from July 1, 2020. The rate of the stamp duty is 0.005% of your investment. This will apply to all investments including lumpsum, Systematic Investment Plan (SIP), Systematic Transfer Plan (STP) and dividend reinvestments. If you transfer units between demat accounts, you will need to pay a stamp duty of 0.015%. Note that stamp duty is not applicable to sale or redemption of mutual funds.
Stamp duty will be debited from your investment when you make it. So, units will be bought after deducting stamp duty from the investment amount. You don’t need to pay for it separately. Will this impact your investment? Not really. You are paying just Rs. 5 for every Rs. 1 lakh of investment. So, if your investment horizon is more than a few months, you can easily recover the amount.
Mutual funds are one of the best investments for all your long-term goals as the costs are minimal. Looking for the right mutual funds? Get in touch with finance experts at wealthzi.com.