In his 2016 AGM, Warren Buffett lauded the role of Sir John Bogle, founder of Vanguard Funds for his role in creating wealth for investors. You need to understand this in a much sharper perspective and why it matters. Buffett has been a value investor all his life and has belief in his ability to select stocks and create wealth. Vanguard, founded by John Bogle, currently has an AUM of over Rs.4.50 trillion and is the second largest fund in the world after Blackrock. Vanguard has been a passive investor in the sense it never gets into stock selection. It is based on the belief that it is hard to beat the market and much harder to select funds that beat the market. Hence the focus should be to invest in good indices which can give solid equity returns with minimal risk and very low costs. Here the focus is on low costs.
Since index funds don’t need to manage money actively, their overheads are much lower and this passed on to the investor in the form of lower TER (Total Expense ratio). When you save 1% expense ratio each year, it can translate into a humongous impact on returns over longer periods of time. According to a study on index funds, Vanguard alone has saved over $500 billion for mutual fund investors since its inception. That has directly translated into wealth for the investors. That is why costs matter.
What are the costs you need to be aware of when investing in mutual funds?
There are some costs that are billed to you annually and some at the time of your transaction. Let look at some of the key categories of costs and how they impact your returns on mutual funds.
Entry loads and upfront transaction costs are the cost you pay to invest in a mutual fund. In India, entry loads existed till 2009, post which it was banned. Brokers are free to charge advisory fees to customers based on the value of service they provide. All other costs will get consolidated into TER, which we shall look at later. The charges that can be levied are as under. For an investment up to Rs.10,000 no fee can be charged. If the investment is more than Rs.10,000 then the fund can impose a Fee of Rs.150 as a one-time charge. This will be applicable for new investors but for existing investors this fee shall be limited to Rs.100. If it is a SIP with a total commitment of Rs.10,000 to the SIP then a nominal fee of Rs.100 can be charged which will be defrayed in four equal instalments from the 2nd to the 5th instalment.
Exit load is levied only if you exit the fund before the stipulated date. It is normally 6 months for debt funds and 1 year for equity funds. Exit loads ensure that the burden of exiting investors does not fall on the continuing investors. Exit load is imposed by funds to encourage equity fund investors to take a more long-term view. Normally, equity funds impose exit load if the exit is before a period of 1 year and it is around 1%, although it may be much higher in specific cases, where the risk in the fund is higher.
Did you know that securities transaction tax (STT) is levied on equity funds but not on debt funds! When equity funds are redeemed, securities transaction tax has to be paid on the sale amount. This amount is imposed at the same rate as is imposed on equity sales in the equity markets. This exit load is imposed irrespective of the holding period and your redemption amount is reduced accordingly.
The total expense ratio (TER) is called the king of expenses and accounts for a large chunk of your total costs in a mutual fund. For equity funds, this cost varies from 2.3% to 2.6%. Although SEBI stipulates an outer limit of 2.5%, there are some exceptions like 0.30% incentive for non-urban sales and reimbursement of GST, which is over and above the 2.50%. Why is TER imposed? The fund needs to incur a plethora of costs like administrative costs, fund management costs, legal fees, auditor fees, registrar fees, brokerage, as well a STT on purchase and sale of equities. These costs cannot be borne by the AMC so it is debited to the corpus. The SEBI stipulation for TER is as under:
Average Weekly Assets
Limit for Equity Schemes
First Rs.100 crore of equity fund AUM
Next Rs.300 crore of equity fund AUM
Next Rs.300 crore of equity fund AUM
Balance assets above Rs.700 crore
While these are annual costs, the proportionate cost is allocated on a daily basis and debited to the end-of-day NAV so that the NAV reflects a clear picture of the net asset value of the fund.
On top of these costs there is tax on dividends and tax redemption. These of course are not fixed costs and can be managed by staying within limits or by opting for the appropriate plan. TER is the one cost where there is a difference between an actively managed equity fund and a passively managed debt fund. Other costs are more or less the same.