What are Mutual Funds
An investment vehicle that is made up of a pool of funds collected from
many investors for the purpose of investing in securities such as
stocks, bonds, money market instruments and similar assets. Mutual funds
are operated by money managers (mostly on a chargeable basis), who invest the fund's capital and
attempt to produce capital gains and income for the fund's investors. A
mutual fund's portfolio is structured and maintained to match the
investment objectives stated in its prospectus.
Are they part of your Portfolio
If you are new to your journey towards financial freedom, you may be having some inhibitions
wrt investing directly in a company's stock. If that is the case, Mutual Funds provide you with a safe mechanism to invest in the equity market and not worry too much about buying and selling at the right time. All this is taken care of by the Mutual Fund Manager, who charges you with certain charges as a % of your total investment in mutual funds.Let us look at what charges are usually deducted from your MF account
wrt investing directly in a company's stock. If that is the case, Mutual Funds provide you with a safe mechanism to invest in the equity market and not worry too much about buying and selling at the right time. All this is taken care of by the Mutual Fund Manager, who charges you with certain charges as a % of your total investment in mutual funds.Let us look at what charges are usually deducted from your MF account
What is Entry Load and Exit Load
Some Asset Management Companies (AMCs) have sales charges, or loads, on
their funds (entry load and/or exit load) to compensate for distribution
costs. Funds that can be purchased without a sales charge are called
no-load funds. Entry load is charged at the time an investor purchases
the units of a scheme. The entry load percentage is added to the
prevailing NAV at the time of allotment of units. Exit load is charged
at the time of redeeming (or transferring an investment between
schemes). The exit load percentage is deducted from the NAV at the time
of redemption (or transfer between schemes). This amount goes to the
Asset Management Company and not into the pool of funds of the scheme. You can easily decipher the entry and exit loads from the account statement that you receive from the Mutual Fund company.
What is Expense Ratio
Here comes the tricky one. The expense ratio
measures the per unit cost of managing a fund. It is calculated by
dividing the fund's total expenses by its assets under management. Asset
management companies (AMCs) employ highly qualified professionals to
track developments in equity, debt and money markets and then transact
accordingly in the asset markets to attain the objectives that are
stated in the fund's offer documents. For such specialised services, the
AMC pays a management fee to the professionals.
There are
operating expenses too, such as the fee for transfer and registrar
agents. They are responsible for issuing and redeeming units of the
mutual fund and providing other related services, such as preparation of
transfer documents and updating investor records. Other than these
charges, a fee is also paid to the custodian, who buys and sells
securities in large volumes. Moreover, there are legal expenses, audit
fees, as well as marketing and distribution expenses.
A mutual
fund recovers such costs through its unit holders on a daily basis. The
daily net asset values (NAVs) of a fund scheme are reported after
deducting such expenses which means that most of us would not even know how much is the expense ratio for the company that is being deducted
You’ve found a no-load fund so that means you’re all set, right? Not so
fast. Loads are only one of the fees to look out for. While not all
funds have loads, all funds do have expenses. These expenses are
expressed in the form of an expense ratio. This makes it easy to compare
apples to apples when looking at multiple funds since the fee is shown
as a percentage.
Unlike a front load you don’t see this expense deducted directly from
your account. Instead, the expenses are built into the fund’s overall
return. So if you pull up your account statement and it shows that your
fund had a 4.3% return, that is your net return after expenses already.
You won’t have a quarterly or annual fee deducted from your account.
That’s why these expenses can be tricky because they are almost hidden
and people don’t really consider the effect they have on returns.
What should you look at?
So, make sure that you look at both the Entry / Exit load prescribed in the Mutual Fund document and you’re also looking at a fund’s expense ratio before
making an investment. The lower the expense the better. If you’re
looking for the absolute lowest fees you should probably stick to index
funds. Since these aren’t actively managed and simply track an index
they can keep costs down. This means you’re looking at usually only
0.10-0.25% expense ratios on index funds. Once you get into actively
managed funds it’s a different story. You might find one fund charging
0.3% and another charging 1.3%, which can make a huge difference on your corpus target
The book "From Rat Race to Financial Freedom" will go in depth in the Mutual Fund world and guide you on how to invest in this asset class, when and how much to invest - depending upon the stage of Financial Freedom you have reached.
Keep investing
Cheers
Manoj Arora
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