Most investors begin their investment journey using mutual funds. I am often surprised when many people approach me seeking advice specifically for investing in mutual funds rather than equities. The surprise is not because I prefer investing in equities over mutual funds (which I do).
The real surprise lies in the perception. Many investors believe that investing in equity-oriented mutual funds is much safer than investing directly in equities. This is a misunderstanding.
Equity-oriented mutual funds are only as good (or as bad) as the investments made by the mutual fund manager. The risks and returns of a mutual fund are directly linked to:
- The underlying stocks held by the fund
- Overall stock market performance
- The fund manager’s experience, strategy, and execution
Most mutual fund managers aim to beat the benchmark index, as this is how performance is measured. In the process, they attempt to time market entry and exit and outperform peer funds in the same category. Even experienced fund managers sometimes end up buying high and selling low.
Historically, it has been observed that around 80% of actively managed mutual funds underperform their benchmark indices over long periods of time.
If the stock market declines sharply or crashes, the Net Asset Value (NAV) of equity mutual funds also falls. During the market downturn from 2008 to March 2009, many mutual funds performed worse than their respective indices.
Most mutual funds have annual recurring costs, such as:
- Asset Management Company (AMC) charges
- Operational expenses
- Marketing and distribution expenses
Entry load is no longer charged; however, some funds do levy exit loads. These expenses are deducted irrespective of the fund’s performance. Even if a fund underperforms, these charges continue to reduce your returns. Unfortunately, most investors do not pay sufficient attention to these recurring costs.
Several mutual funds have delivered poor performance over extended periods, and many New Fund Offers (NFOs) launched in recent years have significantly underperformed the broader markets.
It is important to understand the various expenses involved, such as:
- Management fees
- Administrative charges
- Distribution fees
There are also indirect costs like brokerage costs, interest costs, and redemption-related expenses.
Another important aspect to be aware of is the turnover ratio. The turnover ratio indicates how frequently the fund’s holdings are bought and sold during a given period. A high turnover ratio suggests frequent trading, which can increase costs and impact returns. It also reflects how efficiently the fund’s cash is being utilised.
The objective of this post is to help investors become aware of these factors before investing in mutual funds. Typically, total expenses range between 1.5% and 2.5%, and over long investment horizons, these costs can significantly impact overall returns. Expense ratios vary across funds.
The Securities and Exchange Board of India (SEBI) has prescribed an upper limit on expense ratios:
- Not more than 2.50% for equity mutual funds
- Not more than 2.25% for debt mutual funds
A good mutual fund is one that delivers reasonable long-term returns with minimal expenses and ideally maintains a lower turnover ratio. Investors may refer to independent research platforms such as valueresearchonline.com or mutualfundsonline.com for further analysis.
Investors should also explore Index Funds and Exchange Traded Funds (ETFs). These funds aim to replicate the performance of an index rather than outperform it. As a result, they typically have lower costs compared to actively managed mutual funds.
A separate post on the overview of various types of mutual funds provides a visual understanding of the options available for investment.
Mutual fund charges like expense ratios and turnover costs can significantly impact long-term returns. Understanding these costs helps investors make informed decisions.
Disclaimer
This content is provided for educational and informational purposes only and should not be construed as investment advice, research, or a recommendation to buy or sell any securities.
Mutual fund investments are subject to market risks. Please read all scheme-related documents carefully.
