The dark side of mutual fund fees—What’s really eating into your returns

For the majority of us, the promise of consistent profits and long-term financial progress motivates us to invest in mutual funds. One of the least discussed cons, however, is a seemingly simple investment option that may just be shaving off your profits unnoticed: mutual fund fees.

In India, where mutual funds are often hailed as a convenient way for retail investors to participate in the stock market, many overlook the impact of fees and expenses. Let’s shine a light on the hidden charges you might be paying, and why they matter more than you think.

What are mutual fund fees?

Mutual fund investors pay a mix of fees said to offset fund management costs. Some are spelled out clearly while others are embedded in the gauzy paper that makes up most of this disclosure document. The following represent the most commonly encountered expenses.

• Expense ratio: This expense ratio is an annual cost of a fund as a percentage of your investment. It covers running expenses such as marketing, fund management, and administrative charges. In India, the expense ratio for different types of mutual funds can range from 0.5% to 2.5%.
• Exit load: In case you are selling the units of a mutual fund within a certain specified time, an exit load is charged to you. It varies from 0.5% to 3% of your investment depending upon the policy of the fund.
• Transaction fees: When you buy or sell mutual fund units through a distributor, you may incur a transaction fee. This can add up over time, especially if you are actively trading.

How fees impact your returns

Many investors do not know that charges assessed by mutual funds may consume appreciably into their total net returns. Let's consider an example, as follows:

Let's assume that you invested ₹1,000,000 in a mutual fund, and the returns provided to you were 12% per annum. Here is how your ten-year returns will get impacted when the fund expenditure ratio stands at 1.5%.

• Without charges: An investment of ₹1,00,000 would, after ten years, grow to ₹3,11,000 with 12% returns.
• With a 1.5% expense ratio: ₹1,00,000 would rise to just ₹2,40,000 with a 1.5% expense ratio and no annual 1.5% cost on that money.

In this case, fees alone will see you parting with nearly ₹70,000 in ten years. Consider an example of an individual who has been saving for mutual funds for decades and did not even know what all that money was spent on.

The hidden costs: Expense ratios and beyond

There are additional hidden fees to take into account, even if the expense ratio is the most obvious fee:

• Fund manager’s salary: As the experience and success of the fund manager go up, the cost of managing the fund goes up. Even though these are not usually reported in detail, they are a part of the expense ratio.
• Marketing and distribution costs: It has been the practice that most money that appears highly advertised on the television or on print receives greater costs and it is transferred on to investors. For an ordinary investor, sometimes these "distribution fees" will not appear as obvious.
• Hidden transaction costs: Transaction costs are incurred with each purchase and sale of a security by the fund. Even though you are not charged directly for these, they reduce the total worth of the fund and eventually reduce your returns.

Types of mutual funds and their fees

There are two broad categories of mutual funds in India: actively managed funds and passively managed funds, also known as index funds. The fees vary significantly depending on which type you choose.

• Active mutual funds: These funds are active investment by a professional, purchasing and selling of securities in anticipation of outperforming the market. Consequently, these tend to have higher expense ratios, 1.5% to 2.5%. The guarantee is that returns are going to be higher but at a premium price.
• Passive mutual funds (Index funds): These funds try to mimic the performance of a specific market index, such as Nifty 50 or Sensex. Since they do not need as much management activity, they tend to have relatively cheaper expense ratios, often between 0.1% and 0.5%. If returns are not the highest with the actively managed funds, the saving from cost could be to your benefit in the long run.

The importance of understanding fees

In selecting a mutual fund, there is a need to understand its associated fees. The following steps ensure that one is not overpaying.

• Compare expense ratios: Different funds have different expense ratios, so always compare similar funds before investing. Lower expense ratios could result in higher net returns.
• Check for exit loads: Be mindful of exit loads, especially if you plan to hold your investment for the long term. If you don’t need immediate liquidity, choose funds with no exit load.
• Review your fund’s performance net of fees: Always check how a fund has performed after accounting for fees. A fund that consistently underperforms after fees may not be worth your investment.

The way forward: Minimising fees and maximising returns

One of the best ways to increase returns is by reducing mutual fund fees, as every smart investor knows. The following advice will help you reduce the burden of fees:

• Opt for low cost index: The best available option for a long-term investor could be low-cost index funds with very low expenses and high market exposure.
• Be strategic about choosing funds: It should be one that aligns with your goals and risk tolerance. Actively managed funds, although attractive at times, charge higher costs. If the added cost does not generate better returns, it is probably not justified.
• Inform yourself: Periodically review your investment portfolio and receive updates on modifications to fee schemes or new mutual fund offerings which might be in your best interests.

Don’t let fees drain your wealth

Although mutual funds contribute to an increased wealth of people, they carry with them costs. While the expenses might seem minimal initially, they will soon add up and eat into your profits. It is therefore wise to know about the cost of money so that it can work harder for you by knowing how to pick the right funds and keeping a keen eye on fees.

Look into the fees more closely before investing in any mutual funds in the future. They may just be the hidden negative side of your portfolio. So, take charge and start investing more profitably right now!