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Hidden Costs in Mutual Funds

The costs involved in any investment determine the returns it can generate. In case of mutual funds, the daily NAVs are too volatile, but the costs are never adequately mentioned nor fully understood. These costs vary from fund to fund, just like NAVs and their impact on different categories of funds is different. Always understand that there are hidden charges in Mutual Funds. But it won’t be visible in the first sight.

Costs involved in mutual funds

The costs involved in mutual funds can be broadly classified into two categories :

  • Entry/exit loads
  • Expense ratio

Entry/Exit loads

These are one-time costs incurred when you enter or exit a fund. In other words we can tell that these are the costs involved while buying and selling Mutual Fund. These are charged as a percentage of your investment/encashment amount.

Expense ratio

It comprises some of the major expenses that a fund incurs :

  • Investment management and advisory fees
  • Transfer agent fee and expenses
  • Custodian fees
  • Various operating expenses

Why costs are Important

The answer is very clear- each rupee that a mutual fund charges as cost, reduces your returns by an equal amount. This never means that the mutual fund which has the lowest costs is always better. It just point out how important it is for an investor to clearly understand costs involved in a mutual fund.

On the face of it, a mere 1% difference in costs may not seem important, as long as the returns look attractive. However, even a seemingly minor 1 per cent difference in cost is significant in the long run. Consider an investment of Rs.10,000 in two funds giving the same returns. The net return after accounting for the costs shows a substantial difference.

How to determine fund costs?

Entry/Exit loads and expense ratios of all mutual funds are regularly reported in the financial press and on Websites. The information is also easily available from the funds.

There are certain other costs which mutual funds invite that are more difficult to determine. These include the commission and brokerage fee paid when shares, bonds and other securities are bought and sold. The extent of these costs varies directly with how much, and how often, a fund reorganizes its portfolio. Thus, the higher the portfolio reshuffle, the higher the costs.

For funds with higher turnovers, transaction costs can have a major impact on the cost of doing business. While this invisible cost is automatically reflected in the fund's performance results that is no reason to ignore it. A look at the investment style and policies listed in a fund's prospectus will give you an idea about its portfolio reshuffle policy.

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Mutual Funds
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