The Hidden Costs of Mutual Funds

A lot of people invest in mutual funds because they believe that these mutual funds deliver a better return than they could hope to achieve in their lifetimes. Couple this with the glitzy advertising that mutual funds employ that it is difficult to avoid parting with at least some money to the friendly neighborhood financial advisor.

Nonetheless, the fact remains that past performance is not a measure for future performance. Mutual funds are linked to the markets and markets can move up, down and sideways for years.

The biggest problem of investing in mutual funds is not so much average or poor performance but the fact that most funds perform poorly is because the fund manager and the asset management company take large slices of the profit pie even before it reaches your table.

Costs are the biggest problem with mutual funds and responsible for most of the sub-par performance of the funds. What is worse is that the fund industry go out of their way to hide costs by using complex financial structures and using complicated terms. Most investors lack understanding of these and hence do not question.

Fees can be broken down into two categories:

1. Ongoing yearly fees to keep you invested in the fund.

2. Transaction fees paid when you buy or sell shares in a fund (loads).

The Expense Ratio

Cost of hiring fund managers: Usually 0.5 percent to 1 percent of the assets under management. This may appear small but note that this is the value of the assets and not a percentage of profits. Thus this sum gets deducted before the profits are calculated. Sometimes this could work up to 40 percent of the profits made by this fund manager.

Administrative Costs

Costs of postage, accounting, customer service, rents, staff, etc.

Advertising and Promotions

Brokerage commissions paid when purchasing shares and toward advertising and promoting the fund.

On the whole, expense ratios range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund charges around 1.3%-1.5%.

Loads or Distribution Costs

There are entry loads and exit loads. Loads are costs paid to ensure the funds are available at every nook and corner. They are also called distribution costs. These are paid to the mutual fund agents. The extra kickback you receive from your mutual fund agent is a portion of the load he receives.

Loads comprise entry and exit loads. Entry loads are when you pay a fee to enter a mutual fund. Usually 2-5 percent of the investment. So if you pay Rs 1,000 for the investment in to the mutual fund, you will get just Rs 950 worth of units.

Exit loads are charged if you exit the fund before a certain time period. For example, some funds will charge an exit load if you disinvest before one year while others will lock you in for 3 or 5 years. As the number of years increase the exit load is expected to reduce and in the last year of the lock-in, it becomes zero.

The key to good mutual fund investing is to purchase units of those funds which do not charge any kind of loads.