The Success of Mutual Funds – Costs, Returns & Benchmark Strategies Revealed!

One of the most important aspects of Mutual Funds is the returns that all of us tend to see. But there is another hidden metric that is often underplayed- Costs. While investing money, most investors focus on easy and direct returns. Neither do they think about the “hidden” charges or the yardsticks to measure the performance of their funds.

Our money faces attacks from three sides: inflation, taxes, and product costs. Tax impact is easy to see as we pay them during our redemptions time and again. But inflation and product costs are silently reducing our returns without making a fuss. So, while taxes are upfront, inflation and product costs are slowly eating into our returns.

Indian Mutual Funds probably has the most transparent cost structure in the world kudos to SEBI. In this article let’s delve deeper into the cost aspects of the Mutual Funds and also see how cleverly Mutual Funds are used to benchmark their returns and how SEBI has helped in regularizing the same.

Table of Contents

1. Costs In Mutual Funds
i) Mutual Fund Costs Of Entry:
ii) Costs of Exits
Iii) Cost of Maintenance:
2. SEBI Limits and Expense Ratio Calculation:
i) Expense Ratios of Open-ended Schemes:
ii) Understanding The Setting of Expense Ratios
iii) What do we observe?
3. Expense Ratio in Debt Funds:
i) Expense Ratio Limits:
4. Why Did SEBI Reduce Expenses?
i) What was SEBI’s concern?
ii) What were the issues?
iii) What did SEBI do?
iv) What Can We Investors Do?
5. Measuring The Performance Of Mutual Funds:
i) What is NAV?
ii) How does your Mutual Fund portfolio grow?
iii) Significance of NAV
iv) SEBI Mandates and Cut-off Time:
6. Returns On Mutual Funds
7. Benchmarks in Mutual Funds:
i) The SEBI Touch:
8. Conclusion

1.) Costs In Mutual Funds

i.) Mutual Fund Costs Of Entry:

“No-Load” Mutual Funds:

In India, Mutual Funds are considered “no-load” products. This means no extra charge or commission is added to the price when you buy a Mutual Fund unit.

But this hasn’t been the case since its inception. How much do Mutual Funds charge in fees? Before 2006 the Mutual Fund AMCs were milking the investors to about 2.25 % in the name of front-loading fees.

This cost is for the agents for onboarding new investors onto the Mutual Funds. Since these commissions were high, the agents started to sell too many funds to the investors with the sole motive of making huge commissions.

Another 6% charge known as the New Fund Offer (NFO) fee was applicable during the launch of a new Mutual Fund. Mutual Funds had the liberty to levy this charge, amounting to 6% of the funds collected during an NFO. For instance, a collection of Rs 1,000 crore in an NFO allowed the Mutual Fund to charge Rs 60 crore. This amount was spread over five years, and distributed among investors. The purpose of this charge was to cover the expenses associated with introducing the scheme to the market, including initial advertising and distribution costs.

SEBI had removed both these charges in 2009 and thus it made India the first country to offer all funds with a zero-sales charge embedded in the price of the product.

So other than a stamp duty tax that costs the investor 0.005 percent of the investment amount and the usual bank /platform transaction charges, there is no hidden cost during the purchase process of a Mutual Fund.

You can check one of our earlier blogs on how SEBI has regulated the Mutual Fund industry and understand how the changes have evolved over the years.

ii) COSTS OF EXITS

Exit loads are the fees you need to pay to a Mutual Fund when you withdraw your money. Not all Mutual Funds have exit loads, and the amount can vary between different funds.

If a fund has a 1% exit load and you redeem Rs 5 lakh, 1% of that amount, which is Rs 5,000, will be charged as the exit load, and you’ll receive Rs 4.95 lakh.

Exit loads are in place to encourage investors to keep their money in the fund for a longer time and discourage frequent buying and selling.

Equity funds typically have a 1% exit load to discourage early exits within the first year. This also prompts investors to hold onto their investments for at least a year to qualify for a lower long-term capital gains tax.

Some funds may reduce the exit load as the holding period increases. Fund types like overnight, liquid, ultra-short-term, banking PSU, and gilt funds usually don’t impose exit loads. However, some other debt funds might have a small exit load.

iii) COST OF MAINTENANCE:

Expense Ratio

Expense Ratio is a percentage of your assets under management that the fund deducts to cover its costs and make a profit. For instance, If you have Rs 1,00,000 invested and the expense ratio is 1.5%, Rs 1,500 will be deducted annually to cover the fund’s expenses.

There are two components of the Expense Ratio

• • In-House Expenses: AMC incurs costs like setting up offices, hiring staff (fund managers, analysts, administrative support), and more.

 

• External Services: Costs for external services include fees for registrar and transfer agents, custodians, benchmarking license fees, trustees, and lawyers. For example, the expense ratio covers various behind-the-scenes costs that ensure the smooth functioning and management of the Mutual Fund.

 

Commissions are associated with the Expense Ratio

• Broker and Distributor Commissions: The expense ratio includes commissions paid to brokers and distributors who sell the funds.

2.) SEBI Limits and Expense Ratio Calculation:

SEBI sets limits on the expense ratio, determining the maximum amount that Mutual Funds can charge investors. When you check the expense ratio, it’s shown as a single percentage (e.g., 1.5% or 0.45%), and the calculation method depends on the size of assets under management for that specific scheme.

i) EXPENSE RATIOS OF OPEN-ENDED SCHEMES:

Setting expense ratios based on Asset Under Management (AUM) levels started with Mutual Fund rules in 1996.

ii) Understanding The Setting of Expense Ratios–

Let’s simplify the explanation of how expense ratios are set based on Assets Under Management (AUM) using two equity Mutual Fund schemes as our primary examples:

A. Scheme with Rs 2,000 Crore AUM:

Charge Structure:

• 2.25% on the first Rs 500 crore,
• 2% on the next Rs 250 crore,
• 1.75% on the subsequent Rs 1,250 crore
• Overall Expense Ratio is 1.91%

Mutual Fund Average Expense Ratio: In this smaller scheme, the fund house generates 1.91% revenue based on the charge slabs.

B. Scheme with Rs 60,000 Crore AUM:

Charge Structure:

• 2.25% on the first Rs 500 crore
• Gradual decrease until reaching 1.05% for the last Rs 10,000 crore

What is the average Mutual Fund expense ratio?

In this larger scheme, the average expense ratio is 1.29%, showcasing a decrease as the fund grows. The fund house generates significant annual revenue from this scheme.

iii) What do we observe?

• • Decreasing Average Expense Ratio: Notice that as the fund size increases, the average expense ratio tends to decrease. The expense ratio we see in our account statement is an average that considers different charge slabs based on the AUM.

 

• Strategic Fund Size Management: Some fund houses may strategically keep the size of certain schemes below Rs 1,000 crore to take advantage of higher costs. Larger funds may have lower average expense ratios, while smaller funds could have higher averages.

 

3.) Expense Ratio in Debt Funds:

Expense ratios in debt funds tend to be lower due to presumed lower management costs associated with handling bond portfolios. Additionally, given the generally lower returns in debt products, expenses are intentionally maintained 0.25 percentage points lower. Typically, debt funds experience a swift descent from regulatory ceilings, mainly because they are predominantly purchased by entities with significant bargaining power such as institutions, corporate treasuries, and high net-worth individuals.

i) EXPENSE RATIO LIMITS:

4.) Why Did SEBI Reduce Expenses?

Now that we understand Expense Ratios and how they impact the invested funds, it is time to unveil another mystery– the reduction of expenses imposed by the regulator. Let’s break it down into smaller chunks.

i) What was SEBI’s concern?

In 2019, SEBI intervened because market dynamics were not benefiting investors. Investors were bearing the brunt as both profit margins and distributor commissions were increasing, without any reduction in the prices they paid. So, despite the growth of the Mutual Fund industry, competition did not lead to lower expense ratios as expected.

When the expense ratio limits were fixed in 1996, the size of the Mutual Fund industry was tiny; by the end of 1999, the industry AUM was just Rs 97,028 crore. A decade later, in 2009, the AUM was Rs 6.65 trillion. And in 2018 (just before SEBI reduced expenses) it was Rs 22.85 trillion.

During the same period, the Mutual Fund industry experienced an uptick in profit margins. This rise occurred because costs in the financial sector don’t increase proportionally. Profit margins surged from nearly 19% in 2010–11 to slightly above 35% by 2017–18.

The commission paid from AMC profits rose from 11 percent over 2009–10 to a huge 22 percent in 2017–18.

ii) What were the issues?

SEBI identified issues such as varied charging practices, commissions paid directly by AMC, and the introduction of numerous close-ended schemes impacting the overall Total Expense Ratio (TER). These practices led to an unhealthy environment, causing mis-selling and unnecessary changes in investors’ portfolios. These practices were also diverting money away from investors towards higher distributor commissions.

iii) What did SEBI do?

SEBI took some major decisions to combat this situation. Not only did these actions solve the issues, but they also protected the investor’s interests. In 2019, SEBI implemented the 1.05% as the TER.

iv) WHAT CAN WE INVESTORS DO?

Understanding the significance of expenses is key for investors. While fund houses require fees for their services, investors should verify that the fund manager justifies the additional cost by achieving returns well above the benchmark. If you’re in an active fund, it’s important to ensure the fund manager delivers returns that are higher than the benchmark to justify the extra cost. If not, it might be worth considering a highly affordable low-cost index fund as an alternative. The goal is to make informed investment decisions that align with your financial objectives and optimize returns relative to associated costs.

5. Measuring The Performance Of Mutual Funds:

i) What is NAV?

NAV is a crucial   metric in the world of Mutual Funds. It serves as a key indicator of the value of the portfolio per unit and plays a significant role in various aspects of Mutual Fund transactions and evaluation.

NAV is the price per unit of a Mutual Fund scheme, representing the value of the portfolio minus costs. It is calculated by dividing the total value of the assets in the portfolio by the number of units outstanding.

For example, if a Mutual Fund has assets worth Rs 100 million and 10 million units outstanding, the NAV would be Rs 10 per unit.

ii) How does your Mutual Fund portfolio grow?

Here is how the NAV growth translates into growth in our Mutual Fund portfolio.

The value of the stocks and bonds the MF holds goes up, and that increase is called undistributed profit. Now, this profit hasn’t been given to the investor yet if they’re in the growth plan; however, in the IDCW plan, you might get a piece of it.

Another way Mutual Funds make money for investors is through the interest on the bonds they have and the dividends they receive from shares. When companies issue bonuses or rights shares, those get added to the portfolio too. So, our money in the fund grows through dividends, interest, and profits.

Ok, so all these put together is my final NAV?

Nope, it isn’t the case.

We’ve got to cover the Mutual Fund’s costs, lurking beneath the expense ratio.

Now, if the expense ratio is, say, 2 percent, a daily portion of 2 percent divided by 365 is chipped off from the fund, adjusting your asset value accordingly. Mutual Funds go through a daily ‘mark to market,’ meaning the portfolio’s value is revealed every day, showcasing gains and losses.

So, in short, the resultant NAV at the end of the day multiplied by the number of units we hold will give us the total net worth of our portfolio.

iii) Significance of NAV

• • Buy/Sell Points: For those of us who are in it for the long haul, the daily NAV might not seem like a big deal. However, its daily calculation holds a crucial role—it accurately reflects the real value of the portfolio. This is vital because it sets the price for investors looking to buy or sell their holdings. In simpler terms, it ensures that everyone in the market has a fair and transparent basis for their transactions at any given moment.

 

• Calculate Returns: Since the account management costs have all been deducted from the daily NAV, this will be useful in calculating the returns of our portfolio. So, a simple calculation of the NAV between 2 different points may well give us the return over that period.

 

 

• Higher NAV higher return? A common misunderstanding about the NAV is that it dictates the performance of funds. It’s important to clarify that whether the NAV is lower at Rs 10 or higher at Rs 450, doesn’t directly indicate the fund’s performance. Both are influenced similarly by market shifts, merely representing the current value of the portfolio divided by the total units outstanding. The NAV is more about the fund’s current worth per unit rather than a measure of its performance.

 

iv) SEBI Mandates and Cut-off Time:

SEBI has a disclosure mandate regarding the NAV. Not only this but there is also a “cut-off time” that we need to be aware of in case we are buying the dip type of investors.

SEBI mandates daily NAV disclosure by 11 p.m. for most schemes. For Funds of Funds, it is mandatory to disclose the NAV by 10 AM the next morning.

The cut-off time determines the NAV you get when buying or selling. Orders before 3 p.m. usually get the same day’s NAV, while those after 3 p.m. get the next day’s NAV.

6.) Returns On Mutual Funds

A Mutual Fund functions as a pass-through entity– all funds belong to investors, and the entire return is reflected in the changing Net Asset Value (NAV) over time. This return comes from the underlying portfolio of stocks, bonds, and gold, earned through interest, dividends, and profits.

How is fund performance evaluated in Mutual Funds?

Two common measures are used:

• • Point-to-point return: This measure tracks the day-to-day performance of funds. For instance, if the NAV moves from Rs 10 to Rs 50 over three years, it reflects a 400% return.

 

• Compounded Annual Growth Rate (CAGR): CAGR calculates the annual growth rate of a fund over a more extended period, usually exceeding a year. It’s seen as a more meaningful metric than point-to-point returns, as it considers the time taken for an investment to grow from one point to another.

 

Mutual Funds typically prefer using CAGR over point-to-point returns as it provides a better understanding by accounting for the number of years in between.

Now, there are two types of returns in Mutual Funds: trailing and rolling returns.

• • Trailing Returns: Commonly used, trailing returns show the CAGR over predefined periods like one, three, five, etc. However, they may hide true performance over various periods within a year.

 

• Rolling Returns: Proposed as an alternative, rolling returns assess performance over a more extended period, considering a scheme’s worst and best performance history. This method helps identify return consistency, offering a more comprehensive view of a fund’s performance, including both good and bad phases.

 

For example, a fund with a good trailing return over three years might have experienced significant volatility within that period. On the contrary, rolling returns provide a holistic view, considering various phases of a fund’s performance, aiding in a more informed evaluation of the investor experience.

7.) Benchmarks in Mutual Funds

Benchmarks are standard indices or reference points against which the performance of a fund is measured. These benchmarks act as a yardstick to assess how well a Mutual Fund is performing compared to the broader market or a specific sector.

Mutual Funds invest in a diversified portfolio of assets such as stocks, bonds, or a mix of both. The benchmark helps investors and fund managers evaluate the fund’s returns and understand its relative performance.

If a Mutual Fund’s returns consistently outperform its benchmark, it indicates that the fund manager has been successful in generating positive returns. Conversely, underperformance against the benchmark may signal a need for reevaluation of the fund’s strategy or management.

i) The SEBI Touch:

SEBI with its mandate in 2018 urged the Mutual Funds to use Total Return Indices (TRI) instead of Price Return Indices. Aas a result, the total return indices considered not just capital gains but also interest and dividends, providing a more comprehensive measure.

• • Tier 1 Benchmark: From January 1, 2022, SEBI specified benchmarks for each thirty-seven-fund category to bring uniformity and clarity to investors. For example, the large-cap category can choose either the Nifty 100 or the S&P BSE 100 TRI as a benchmark. A conservative hybrid fund can choose either the Nifty 50 Hybrid Composite Debt 15:85 index or the CRISIL Hybrid 85+15 conservative index.

 

• Tier 2 Benchmark: The initial benchmarks, also known as first-tier benchmarks, brought attention to issues at a surface level. For example, a portfolio consisting solely of triple-A rated bonds needed a different benchmark compared to a portfolio with a more diverse mix of assets. The first-tier benchmarks struggled to provide a nuanced analysis of funds within the same category. Consequently, the need for a more sophisticated approach led to the introduction of second-tier benchmarks. These second-tier benchmarks aimed to offer a deeper and more refined evaluation of funds, considering the intricacies of their specific compositions and risk profiles.

 

However, SEBI does not specify much about the second-tier benchmarks. This allows managers to showcase their ability to beat a subcategory of the benchmark, aligning with their investment philosophy.

All right, let’s simplify things. When checking how well a Mutual Fund is doing, focus on a few key benchmarks. Start with the big ones like Sensex and Nifty 50 – these are like the overall scores for the whole market.

Next, look at the benchmark for the specific category your fund belongs to. For example, if it’s a fund investing in large companies, check the benchmark for large companies.

Finally, check out the average return for all the funds in that category. This gives you an idea of how everyone is doing in that specific group.

So, in simple terms, it’s like comparing your fund’s performance to the big market scores, then to the specific category’s benchmark, and finally, seeing how it stacks up against the average returns of other funds in the same category. This way, you get a good sense of how well your fund is playing the game compared to others and a better idea of how to save on Mutual Fund costs.

8.) Conclusion:

A good investor is always vigilant– he or she assesses the hidden costs and the performance of the funds they have invested in. As it is easy to hide costs using jargon and difficult phrases, investors should have the eye for the right detail. In case the problem is still unsolved, they can ask their financial advisors about these costs and know what they are signing for.

Not just this, investors should also use proper measures to check the performance of their funds. While rough estimates and figures work sometimes, you have to use proper methods like NAV (Net Asset Value), CAGR, and Benchmarks. Benchmarks help investors gauge a fund’s success with the broader market or a specific index.

Avoid becoming stuck in false beliefs about mutual funds by believing everything you see on social media platforms like Quora, Facebook, Twitter, and the like. It’s advisable to speak with a qualified financial planner to clear your prejudices.

Happy Investing!