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The bitter truth about Indian mutual funds: Part 1

Source : SIFY
Last Updated: Thu, Jan 31, 2013 09:01 hrs
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Investopresto defines a mutual fund as a "pool of money managed by investment professionals to meet certain investment objectives." Most experts would agree that investing in a mutual fund is probably the best and cheapest way in which a small investor can build a diversified investment portfolio. But, did you know that if you aren't careful while choosing the funds you invest in, you can end up throwing your hard-earned money into the drain? Yes! Loads and invisible expenses can take more than just a bite from your investment returns, leaving you high and dry. Let us see how.

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Caption: Are you carrying your mutual fund's load?

Loads and Expenses

Till SEBI abolished entry loads in 2009, most funds would charge 1% to 3% of the invested amount as "entry load". Most funds still charge an "exit load" of between 1% and 3% of the NAV of the fund (price of each unit). In fact, some funds charge as much as 3% of the NAV as exit load if units are redeemed within 6 months of purchase. However, if units are held for longer than 1 year, many funds charge no exit load. Investors in mutual funds end up paying for the operating expenses of the fund. Examples of such expenses include marketing/sales costs, salary/bonuses paid to the fund managers, auditing/legal fees etc. These costs are directly deducted from the NAV of the fund and therefore, most investors don't notice them.

Your financial advisor most likely has a major conflict of interest

Did your financial advisor tell you that he doesn't charge you for his advice? Well, that is a half-truth. Most financial advisors are paid between 0.5% and 1% of the amount you invest through them. Guess who pays them? The mutual funds of course! So, if you were to invest Rs 1 lakh in Fund X through your financial advisor, he most likely gets paid between Rs 500 and Rs 1000 by Fund X for selling you the fund.

Sounds harmless, right? There are hundreds of mutual funds available in the market, many of which perform much better than the rest. Will your financial advisor recommend the best performing fund or the fund which gives him the highest commission? Just asking....

Lesson 1: Ask your financial advisor if he gets paid commission for selling you a particular fund and on what grounds he is recommending that fund. Ask if it outperformed its peers in the past and if he has any reason to believe that it will continue to do so in future.

Your returns were eaten up for breakfast by loads and expenses

Suppose you had invested Rs 100 in a certain mutual fund. Suppose you pay 0 entry load and 3% exit load (Certainly possible. See below). Also suppose that the expense ratio of the fund is 2.5%. You are, in effect, losing 5.5% of your fund's NAV to loads and expenses. What if your fund returned 12% over the course of the year? Then, you effectively lost 5.5% of Rs 112 or Rs 6.16. You are left with a return of 5.84%.

What if it was a bad year and your fund lost 10% of its value? Your loads and expenses would then amount to 5.5% of Rs 90 i.e. Rs 4.95. Your net return would then be -14.95%! It is important to note that you will most likely not notice expenses since NAVs are calculated after taking into account expenses.

Just in case you thought that we were exaggerating

We took a cursory look at some of the top fund houses to see how much they charge as loads and expenses. We are not saying anything; you take a look at the results for yourself. Note that this is not an exhaustive list. Feel free to look at a fund's website to see its load structure and expense ratio.

Lesson 2: Go online and see how much the expense ratio, entry load and exit load of a fund is, before you invest in it.

Fund

Entry load

Exit load

Expense ratio

ICICI Prudential Dynamic plan

-

0-3%

Upto 2.5%

ICICI Prudential Tax plan

-

0%

Upto 2.5%

HDFC Equity Fund

-

0-1%

Upto 2.5%

HDFC Midcap Opportunities fund

-

0-1%

Upto 2.5%

Franklin India Bluechip fund

-

0-1%

1.81%

Axis Equity Fund

-

0-3%

2.20%

What next?

We will look into the performance of mutual funds over time and see whether they beat their benchmark indices or not, whether it was worth investing in them at the end of it all.

Ashwini Anand, CFA Ashwini Anand

The author, Ashwini is the founder of Investopresto, a next generation investment portal with social features that lets friends share investment information with each other, to enable them to make smart investment decisions.

Data Sources:

Investopresto's Mutual Funds comparison tool , ICICI Prudential AMC's website, HDFC Mutual , Fund's website, Franklin Templeton India's website , Axis Equity Fund's page on Investopresto

Photo source: trekearth.com




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