Avoid Mutual Funds with Hidden Costs

Avoid Mutual Funds with Hidden Costs and increase the chances of earning index-beating returns. 

We all are quite familiar with the mutual fund expense ratio and we rightly desire that it reduces as much as possible. A recent circular of SEBI has further lowered the cap on mutual fund charges in a regular plan.

The growing popularity of Direct Plans further catalyzed by PayTM’s entry into selling mutual funds is a testimony to the importance of costs when investing through mutual funds.

But how many of us realize that there are costs that are not visible in the expense ratio that impact the returns that we earn in Mutual Funds?

What are these ‘hidden costs of mutual funds?  

Brokerages and Impact cost!

Yes. Just like us, funds have to pay brokerage when buying and selling a stock. Brokerages are not reported separately but the NAV is calculated after deducting the brokerage fees.

SEBI has a cap on brokerage charges of 0.12% on every transaction for mutual funds. So if a fund buys and sells, it has to pay these charges that get deducted from our corpus.

Obviously, we can’t avoid these fees but can the fund reduce them? But how to determine how much brokerage a fund may have paid? The shortcut to check this is by looking at the Turnover Ratio of a fund that is available in the factsheet.

This factsheet is published monthly. Alternatively, you can also check this on the MoneyWorks4me.com website.

This ratio is reported as a percentage of its portfolio. A fund has a turnover of 100% means it rotates the whole portfolio in 1 year. Another way to look at it is, that even if a few stocks may stay the same, the remaining portfolio might be shuffled two-three times over. Similarly, if it is a turnover of 20%, it means a fund changed 20% of the portfolio in one year that is, it typically holds a stock for 5 years.

If stocks are held for one year bought & sold, the brokerage cost for a fund with a 100% Turnover Ratio would be 0.12%X2 =0.24% on the overall fund. This 0.24% went out of our investment. For 20% turnover fund, it would be 20% of 0.24% i.e. 0.058%. So you see this is drastically lower than the 100% Turnover fund.

Please remember whatever we save compounds and hence has a significant impact, especially when delivering benchmark returns is not easy and getting more difficult going forward. Hence Lower Turnover Ratio fund must be preferred.

Coming to another big hidden cost - Impact Cost.

What is Impact Cost?

Since funds have to buy or sell a large block of stocks, they do not get a seller or a buyer at their desired price. They have to settle with slightly higher costs for acquiring a large block and a lower than reported price when selling a large block. This leads to a reduction in returns earned.

This can amount to as large as 1% of a portfolio in a 100% Turnover Ratio fund. Impact costs are another hidden cost that eats into our corpus. For a lower Turnover Ratio fund, this cost would be lower too.

Research has shown that low churn reduces cost and adds more value in the long term than picking stocks for short term positive movements. Given that fund managers are very intelligent professionals, they must be taking these decisions despite knowing this.

The only reason then is that they are driven to show short term performance even at the cost of what is good for long term investors.

As investors in mutual funds where we are rightly told repeatedly to stay invested for the long term, isn't it wise to prefer funds managers who rotate their portfolio less and still deliver?

We recommend only buying mutual funds that have a lower Turnover Ratio. Though in the past many Indian Mutual Funds have beaten the market, the future won’t be as good due to the increase in competition and that outperformance reduces as the market gets developed.

The reason that Index Fund, a statistically constructed portfolio, is hard to beat is that it has low brokerage costs and low impact costs. The turnover ratio of an index fund is much lower and this gives it an edge.

Buying good funds with a low Turnover and Expense Ratio assures us that we are with a fund manager who is more likely to beat the index and hence justify our investment in them.

Read the article to know: Mutual Fund Expense Ratio: How much is fair?

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