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All You Need to Know About the Hidden Costs in Mutual Funds Investments

Editorial and Content Intern, TRANSFIN
Jan 9, 2021 9:06 AM 6 min read
Editorial

“Mutual fund investments are subject to market risks…” shows your investment is sparse and brisk.

While that may be the case, what do you need to watch out for while investing in them, aside from the market risk part? 

Whether you’re a fresher or a seasoned investor, it is always useful to keep up with the times when it comes to details one may be too busy to notice - be it various charges (hidden or convoluted) and taxation.

What’s left for you to do is find the formula that works best for you.

 

 

Exit Loads

Investment in a mutual fund is done with an Asset Management Company (AMC). An AMC collects a pool of funds from various investors and invests that money in a diversified set of securities. One has to purchase units of the fund depending upon his investment size and the price of each unit (known as Net Asset Value- NAV). NAV is calculated as the assets minus the liabilities of the entity divided by the number of units outstanding.

When exiting or redeeming the units as an investor before the lock-in period has lapsed, an exit load may be charged. These are usually to cover distribution costs incurred by the AMC. It can also dissuade an investor from exiting before a specific period of time. The exit load rate varies from AMC to AMC.

The exit load is usually calculated as a percentage of the NAV at the time of redemption of the mutual fund. So, the amount deducted will be the specified percentage of the total NAV of your investment that you are redeeming. The remaining proceeds of your investment will be transferred back to you.

Thus, if the investor redeems their units before the specified time period, the exit load is activated which eats into the returns that they may have received on maturity. 

When it comes to a Structural Investment Plan (SIP), the investor invests a fixed amount at regular intervals. The exit load is applicable to every instalment. The lock-in period is in effect for a specific duration after the last investment is made.

 

Expense Ratio

Every AMC is allowed, as per SEBI guidelines, to charge an annual maintenance fee for its expenses from investors. The value of this expense ratio depends on the size of the company, which determines what proportion of the investment is needed for management. It is calculated as the total expenses of the scheme divided by the Assets Under Management (AUM). 

Mutual fund schemes come in two categories - Direct and Regular. Under the direct plan, no commission to a broker or agent is paid whereas it is payable for the regular plan. So, the direct plan is likely to have a lower expense ratio. However, market expertise and understanding on which fund will suit your objectives is a tricky affair which is why an intermediary can be beneficial.

Then there's the Total Expense Ratio (TER) which is essentially the cost that an investor incurs for portfolio management. Since it is calculated as a percentage of the total fund assets, the returns that an investor can expect are directly affected. 

The Total Expense Ratio usually has these components:

  1. Management Fees - The fund manager’s expertise and decisions usually affect the returns gained by an investor. The manager’s compensation comes under this.
  2. Administrative Cost - The functioning of a mutual fund involves various costs in terms of customer service, legal costs, etc. which are covered herein.
  3. Marketing Expense - This is the annual advertising and promotional fee. The AMC charges investors this fee to promote the fund and is recognised as operational expenses. The marketing and selling expense includes agent commission as well.
  4. GST - For any service provided by the fund, such as management, GST at 18% is payable.

The lower is the percentage charged, the higher is the profitability for the investor. Statistically speaking, a 1% difference in the expense ratio charged (which means an equivalent difference in returns) can depress returns by 6% over 10 years.

For open-ended schemes, SEBI has determined the rate that can be charged on average net assets per week as total expense ratio is:

  • Up to ₹100cr ($13.7m): 2.5% for equity funds and 2.25% for other funds
  • ₹100-300cr ($13.7m-$41m): 2.25%  for equity funds and 2% for other funds
  • ₹300-600cr ($41m-$82m): 2% for equity funds and 1.75% for other funds
  • On balance assets: 1.75% for equity funds and 1.50% for other funds

 

For close-ended and interval schemes in case of equity funds, TER is capped at 1.25% of the daily net assets of the scheme. For funds other than equity funds, the cap is at 1.00%. Mutual funds can charge up to 30bps more “if the new inflows from retail investors from beyond top 30 Cities are at least (a) 30% of gross new inflows in the scheme or (b) 15% of the average assets under management (year-to-date) of the scheme, whichever is higher.”

An investor can find out the TER charged on the AMC website itself which usually falls under a separate header. Association of Mutual Funds of India (AMFI) which is a regulatory body also provides information regarding TER.

 

Taxes

The gains from mutual funds investments are taxable. The revenues are earned in two ways - capital gains and dividends.

Capital gains is the difference between the amount invested by the investor to purchase mutual fund units and the price at which those units were redeemed. The taxation depends on the holding period or the time for which an investor has his investment with the AMC before redemption. The taxation is as follows:

  • For equity-oriented schemes

Short term (up to 12 months) - 15%

Long term (more than 12 months) - 10% without indexation

However, under Long-Term Capital Gains on equity mutual funds, gains up to ₹1 lakh ($1,367) are exempted. Equity-Linked Savings Scheme (ELSS) is an equity scheme with a lock-in period of usually, 3 years. The funds, therefore, cannot be redeemed before the lock-in period is up. It qualifies for a tax deduction of ₹1.5 lakh ($2,050) per annum.

A Securities Transaction Tax (STT) at the rate of 0.001% is payable on equity schemes when redeeming the units. This is directly deducted from the mutual funds returns and is not payable separately.

  • For debt-oriented schemes

Short term (up to 36 months) - Income tax slab rate of investor

Long term (more than 36 months) - 20% after indexation

  • SIPs

Taxation is on a pro-rata basis. Every instalment under this plan is a new investment, so the gains received are taxed accordingly. 

Indexation means adjustment of capital gains to the Cost Inflation Index (CII), which is applicable to long-term capital gains in order to reduce taxes. The CII can be found on the website of the Income Tax Department. 

Head to the link here.

A dividend is that part of the company profit which is distributed among investors. Up until FY20-21, Dividend Distribution Tax (DDT) was paid by the company declaring a dividend. Now, the burden has been shifted to the investor. As per the Finance Act, 2020, TDS is applicable on dividend income that is more than ₹5000 ($68) from an AMC. The tax rate is a standard 10%. 

Further, the dividend income is also taxable for the investor. The DDT rate is the income tax slab rate of the investor and falls under the head of income from other sources. Interest expenditure that an investor incurs against the dividend is available for deduction up to 20% of the dividend income received.

 

Let's Get Started

These are the various expenses and charges that an investor must know before setting off on their investment journey. The best part about mutual funds is that you can get started with as little as ₹500 ($6.8). If you’re still new to the world of investing, they’re a relatively safe avenue to start from. As always, it is important to know the purpose behind your investments and accompanying that with well-rounded research. Soon, you’ll be as obsessed with investing as we are. For lack of a better phrase -  the feeling is mutual!

FIN.

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