In this Samco Investor Education Series,we will discuss indirect mutual fund fees in the form of cover a topic on Exit Loads & Expense Ratios. one of the most popular investment avenues among investors nowadays. In this article, we will also have an in-depth look at what are entry & exit loads, what expenses are charged in terms of TER (Total expense ratio), how TER affects the investments, evaluation of best performing funds after deducting these charges and a lot more which will be help to the investors to make informed investment decisions.
Mutual Funds are basically a pool of funds where various investors invest their money. This pool of money is then carefully invested into different asset classes like equity, debt, real estate, gold etc according to the investment objective of that mutual fund.
At the time of selecting a mutual fund scheme for investment, an investor should consider various parameters such as its past performance with respect to its benchmark, category average, market capitalization, asset allocation pattern, fund manager’s qualification & experience, risk factors, etc.
Another important parameter that can help the investor to select a suitable fund is its expense ratio. Expense ratio is charged asset management companies for managing the investment portfolio and generatinghigh returns for clients.
What is Entry load & Exit load?
An Asset Management Company (AMC) collects a fee from the investors when they invest into or withdraw from a mutual fund scheme. This mutual fund fees is generally referred to as a ‘load’.
Entry load is a fee charged to an investor by the AMC at the time of investing into the scheme. Exit load is a fee charged to the investor for exiting or leaving a scheme before a certain period of time.
In general terms, an entry load is a fee collected from an investor as a fixed percentage on his invested amount to cover costs of distribution by the company. Different mutual funds houses charge different mutual fund fees as as per their expense structure.
In India, this charge was usually between 2-2.50% of the value of investment. However, from 1st of August 2009, SEBI has banned entry load for all mutual funds.
However, exit load charged by different mutual funds fees may slightly differ for some schemes. So investors are advised to check the exit load of the scheme from the SID (Scheme Information Document) or KIM (Key Information Memorandum) of the particular scheme which are readily available on respective Mutual fund’s website. The main motive behind these mutual fund fees and expenses to discourage investors from redeeming early (within a year) .
How exit load is calculated by the AMC?
Exit load in a mutual fund is a charge by the Asset Management Company for the redemption of the mutual fund units by investors before a fixed time period. The table below explains how much exit load will be charged for different mutual fund schemes.
|Equity oriented funds : |
For equity-oriented mutual fund schemes, exit load is a fixed percentage of the market value of investments at the time of redemption. Usually, 1% in equity funds only if redeemed within 1 year of investment. No exit load is applicable if investments are redeemed after 1 year from the date of investments.
For eg. An investor invests Rs. 1,00,000/- in a Reliance Growth Fund which is equity-oriented fund. After 6 months, the market value of the investment has grown to Rs. 1,20,000/-. If he/she wants to redeem their investment at that time because of some financial requirement, they will be charged 1% exit load on the market value of 1,20,000/- which comes to Rs. 1200. On the other side, if he/she stays invested for the period of 1 year or more, they won’t be charged with the exit load at the time of redeeming their funds.
|Debt oriented funds: |
For debt oriented mutual fund schemes it is usually 3% of the market value of the investments if redeemed within 1 year, 2% if redeemed within 2 years & 1% if redeemed within 3 years of investments. This type of structure is called as “Contingent Deferred Sales Charge” or CDSC because the load decreases as the investment horizon increases. No exit load is applicable if investments are redeemed after 3 years from the date of investments.For eg: An investor invests in Franklin India Credit Risk Fund which is debt-oriented fund that has a CDSC structure for exit load.If an investor want redeem his/her funds under this,
|Liquid or Ultra-short term funds : |
This category of the funds is suitable for very short term investment, like parking money temporarily just for 3 to 6 months in an instrument which can fetch 1-2% more than a savings bank account. No exit loads are applicable to this type of funds as the investment objective of the funds itself is to manage money for a very short tenure.
However, all these mutual fund fees and expenses are a general figure of all mutual funds and may differ slightly from scheme to scheme. Investors are advised to check before investing, the load applicable for the specific scheme from SID or KIM of the scheme from mutual fund’s website as mentioned earlier.
The asset management company retains the exit load and it is not considered to be a part of the scheme’s earnings. The idea of exit load is to discourage investors to make untimely exits from mutual funds.
What is the Total Expense Ratio (TER) in a Mutual fund?
The expense ratio is the cost per unit of managing a fund. Asset Management Companies (AMCs) employ highly qualified professionals to track developments in equity, debt and money markets and then transact accordingly.
A separate mutual fund fees is also paid to the custodian, who buys and sells securities in large volumes. There are operating expenses too, such as the fee for the registrar and transfer agents, who are responsible for issuing and redeeming units of the mutual funds and providing other related services, such as preparation of transfer documents and updating investor records such as KYC. Mutual fund fees and expenes also includes Moreover, there are audit fees, legal expenses, marketing and distribution expenses etc.
To sum up, total expenses of the AMC includes scheme specific charges to cover the costs of research done by the AMC and its professionals, manage the portfolio of securities and for providing related services to investors.
The expense ratio is adjusted by the AMC in the Net Asset Value of the fund itself. The Net Asset Value (NAV) which we see daily is calculated after deducting these expenses. However, the expense ratio of a fund is disclosed once every six months.
The expense ratios of equity and debt funds are different. Since the expenses of equity funds are more than those of debt funds because of the higher fund management costs and charges, an expensive mechanism to bulk trade in the highly volatile equity markets, the expense ratio of equity funds is higher.
There are 3 major types of expenses that form a part of Expense Ratio:
Mutual funds are a sophisticated product which requires formulation of investment strategies before actually investing money in the underlying assets. Fund houses appoint professional fund managers to manage the fund’s assets. They need to possess a high level of educational, relevant fund management experience and professional credentials. The management fee or investment advisory fee is used to compensate the managers of the portfolio. On average this fee is annually about 0.50% – 1.0% of the fund’s assets.
The administrative costs are the expenses to run the fund. This would include record keeping, customer support & service, information emails and communications. These costs can vary greatly and are expressed as a percentage of fund assets.
The distribution fees is collected by most of the mutual funds for advertising and promoting the fund. Most mutual funds charge their unit holders to market and promote the fund to the investors.
These three fees mutual fund fees and expenses combined are equal to the percentage of assets deducted from the fund which is also known as the mutual fund’s Total expense ratio (TER).
Calculation of expense ratio :
- If an investor invests Rs. 1 lakh in a mutual fund at a NAV of Rs. 10 and the expense ratio is 2%, after one year, there is a gain of 15% on the NAV. So, the value of Rs. 1 lakh has gone up to Rs. 1.15 lakh.
- However, after a deduction of 2% charge, the amount is reduced to Rs 1,12,700. AMC will adjust this expense ratio of 2% in the NAV of the scheme itself so NAV will be reflected as Rs. 12.7 instead of Rs. 15 which was before adjusting expenses.
- The impact of expense ratio is greater in case of debt funds, which earns 8-9% on an average. For an investor of an equity fund, paying 2% from an average return of 15-20% may not pinch, but it will hurt to pay 2% in case of an 8-9% average return for debt funds.
A lower ratio means more profitability and a higher ratio means less profitability.
Expense ratio becomes critical in case of debt funds especially in a universe of low yields. Apart from that, an investor may use expense ratio to differentiate between actively managed and passively managed funds.
In case of actively managed equity funds, the alpha (a parameter which shows outperformance of fund returns as compared to benchmark returns) generated by the fund manager is a crucial justification of the expense ratio charged by the fund.
If an investor finds a wide divergence between the returns of the fund in which he has invested and index funds which replicate the market, then he may consider making a switch from that fund to a good performing fund. Hence, it becomes important to know how much an investor is paying to the fund.
Although high expense ratio impacts the fund returns, it is not necessary that high expense ratio will always give low returns. If the funds are managed in an aggressive manner then high returns can be an outcome of high expense ratio due to the choice of investment and good stocks in the asset.
Let’s consider an example of 2 mutual funds to draw a comparison.
Fund A has a higher expense ratio and Fund B has a lower expense ratio.
|Total expense ratio (TER)||3%||1.80%|
|No. of units||1000||1000|
|Returns generated in one year||20%||12%|
|NAV at the end of one year (before adjusting TER)||120|
|NAV after adjusting TER||116.4|
|Market value after one year||1,16,400||1,09,980|
|(Units × Prevailing NAV)||(1000×116.4)||(1000×109.98)|
From the above table we can see that Fund A has given 20% return in one year and despite having a higher TER, market value of 1,00,000 has grown substantially as compared to Fund B which had a low TER.
So the point here is to understand that even though expense ratio is an important criteria while selecting a fund, it should not be the only thing investors should look at while making an investment decision.
Many times funds with higher expense ratio justify their higher costs by their performance, just like Fund A.
Maximum TER for Mutual Fund Schemes:
As per the latest regulations of the Securities and Exchange Board of India (SEBI), a maximum TER a mutual fund can charge for closed ended equity schemes is 1.25% and other than equity schemes is 1%. The maximum TER for open-ended equity schemes will be 2.25%.
All expenses incurred by a Mutual Fund AMC will have to be managed within the limits specified under Regulation 52 of SEBI Mutual Fund Regulations. As per these regulations, the total expense ratio (TER) allowed is,
|on the first Rs.500 crores of the daily net assets||0.05||0.05|
|on the next Rs.250 crores of the daily net assets||0.05||0.0175|
|on the next Rs.1,250 crores of the daily net assets||0.0175||0.015|
|on the next Rs.3,000 crores of the daily net assets||0.016||0.0135|
|on the next Rs.5,000 crores of the daily net assets||0.015||0.0125|
|On the next Rs.40,000 crores of the daily net assets||Total expense ratio reduction of 0.05% for every increase of Rs.5,000 crores of daily net assets or part there of|
|On balance of the assets||0.0105||0.008|
The TER for index schemes, Exchange Traded Funds (ETFs) and Fund of Funds shall be maximum of 1%. The TER for fund of funds (FoFs) shall be a maximum of twice the TER of the underlying funds.
– FoFs investing primarily in Liquid, Index and ETF schemes: Total TER (including the TER of underlying schemes) shall be maximum of 1%.
– FoFs investing primarily in active underlying schemes: Total TER (including the TER of the underlying schemes), shall be maximum of 2.2%.
Comparative analysis of Expense Ratios :
Expense ratio can be an important criterion in the selection of mutual funds because it impacts the overall returns earned by the unitholder.
The following table illustrates the expense ratios charged by different mutual funds. Here we can see that the expense ratio is higher for the equity-oriented schemes because of higher costs associated with equity funds as compared to debt funds.
|SBI Bluechip Fund||Equity – Large Cap||2.35%|
|L&T Midcap Fund||Equity – Mid & Small Cap||2.35%|
|Axis Long-term Equity Fund||Equity – ELSS||2.25%|
|Aditya Birla Sunlife Regular Savings Fund||Debt – MIP||2.10%|
|SBI Magnum Medium Duration Fund||Debt – Medium Duration||1.46%|
Though the expense ratio is important, it should not be the only parameter while selecting a mutual fund scheme. A scheme with a consistently decent track record, a fund manager with a higher success rate of picking quality stocks and securities but a higher expense ratio may be at par or even better in some cases with the one with a lower expense ratio which can give a lower return due to the suboptimal choice of investments.
Many times investing in mutual funds might be an anxious activity because of the timing of investment and nature of financial markets. It involves the analysis of numerous qualitative and quantitative factors across different time intervals. Additionally, an investor needs to keep in mind his financial goals, investment horizon and risk appetite.
In case tracking the financial markets isn’t your thing and you are finding it too difficult to understand, then just go to our Investor education section for more details. You can invest in hand-picked funds in a hassle-free and paperless manner through our website RankMF.com.
(Note: This content is for information purpose only. Avoid trading and investing based on the information given above. Before investing in stocks or mutual funds, please conduct proper due diligence).