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How these hidden expenses of mutual fund schemes can eat into your returns

How these hidden expenses of mutual fund schemes can eat into your returns

25 Oct 2021

You buy an air ticket that costs say, Rs 6,000, for which the airline will fly you from Delhi to Mumbai. The nature of the transaction is clear in your head. You give the airline money and the airline uses that money to fly your from one city to the other. Consider an alternative situation. When you get to the airport you have to pay Rs 300 to enter the airport. You also have to pay the government, say a separate Rs 2,700 for the tax on the fuel and again for the GST. However, the airline ticket costs only Rs 3,000. Basically, there is no difference between the two situations.

However, the nature of the transaction in your mind is completely different. It becomes clear to you that the airline, which is spending on the aircraft, the pilots, the fuel and so much else is doing an almost heroic job and most of the money that you are paying is going somewhere else. The airline is basically a collection agent for various other entities. If you were to start paying for each part separately then many things would become much clearer.

Let’s apply this principle to some financial services. You buy an insurance policy, a Ulip or a traditional policy. You pay a certain amount and you get some combination of life cover and future investment value out of it. It’s pretty hard to understand what part of the service was worth it and what was not. Now imagine if each part of the money that you pay was billed separately and was paid separately according to what it was used for. The money that you pay for such a policy goes into four buckets broadly. Some is used to fund a life cover for you. Some is an investment, which you will eventually get back at a (hopefully) enhanced value. Some is paid to an agent as a commission and some is kept by the insurance company for its own expenses and profits.

Suppose you were billed separately for each. Every year, instead of paying say Rs 2 lakh under one head, you paid in separate transactions for each of the above four components. My guess is that you would become a much smarter shopper of insurance products and insurance companies and agents would have a much harder time selling to you.

Now consider mutual funds. Mutual funds charge a certain expense to manage your money. This is a percentage of the total value of your investments and roughly ranges from almost nothing to about 2.5%. For actively managed equity funds it’s towards the higher end of the range, obviously. Unless you dig into the communications that the fund sends you or you have a research mindset and spend time on Value Research Online, you are unlikely to have any idea of how much you are paying for having the mutual fund company manage your money and whether it’s worth it.

“Unless you read what the fund sends you or you have a research mindset, you won’t know how much you are paying for what.”

— Dhirendra Kumar

That’s because the expenses are deducted in tiny amounts every single day from your NAV. This makes them invisible to you. Suppose the rules were different. Suppose your NAV just reflected the actual investment value and the fund company billed you quarterly for expenses. I know this would be very cumbersome but this is a thought experiment so please bear with me. Now every quarter your thinking would go something like this: this fund has Rs 10 lakh of mine, on which they made Rs 30,000 returns and now they’ve sent me a bill of Rs 5,000. So they want one-sixth of the money back! For making Rs 30,000 they are charging Rs 5,000. Note that these are realistic numbers, in fact they are on the optimistic side. There would also be quarters when the fund company would lose you money and would then send you a bill for that ‘service’.

What would happen if this actually happened is that you would mentally calculate the expenses as a percentage of gains while the financial industry (all parts of it, not just mutual funds) wants to charge you as a percentage of the total money, including the part that was always yours to begin with.

I’m not going to offer a closing view in this column. I’ll just leave this here for you to mull over everything I’ve written and tell me what you think. In a week or two, after I have digested what people have to say, we’ll come back to this topic.

(The author is CEO, Value Research)