Question

What are the costs of mutual funds?

How are these costs summarized?

How do mutual funds differ from ETFs?

Answer 1

Following are the common costs of mutual funds

1. Mutual Fund Charges

Where there is a mutual fund, there is an Asset Management Company (AMC). And where there is an AMC, there is a fund manager. A fund manager is supported by a team of financial analysts and market experts in the backdrop. Managing such a massive amount daily while striving to overcome market risks is no mean feat. It needs subject expertise, industry experience and a fair amount of passion. Therefore, the mutual fund company charges a SEBI-approved for their services.

2. Expense Ratio

Sometimes, the expense ratio is synonymous with mutual fund charges. And at other times, there could be other investment expenses too, which investors need to pay.

Expense ratio or the fee to the fund house from individual investors is what motivates an asset manager to deliver stellar returns. The more they deliver to their investors, the reputation of the AMC and fund manager increases. Hence, investors’ satisfaction is their ultimate goal. One happy customer means not only steady investments in future but also more investors. This is capable of increasing the assets under management (AUM). All of this comes at operational costs. Now, let’s explore various mutual fund charges and their relevance to investors.

3. Types of mutual fund charges

Cost incurred for the investor is summarized into two types of charges – One-Time Charge and Recurring Charge. However, there are many variations to them as given below.

a. One Time Charge

One-time charges are those that incur during the initial period for the investment. It’s basically buy-in tariff, taking poker table as an example. It’s also referred to as a transaction charge.

b. Load

A load is basically a commission or fee. AMCs or intermediaries usually collect it before you invest or after. Sometimes, redemption charges or early withdrawal charges are also levied on investors. You must be familiar with the entry load and exit load of a mutual fund.

c. Entry Load

When an investor has to pay a nominal charge when he purchases a fund unit, it is called an entry load. Not all funds levy this. SEBI deferred this in August 2009 for mutual funds alone.

d. Exit Load

This is a fee levied on investors when they decide to redeem their mutual fund units. The rate for this is not fixed.

Exit load is variable and falls in the range of 0.25% to 4%, depending on the scheme. The fund houses decide this fee, mainly to make people stay in for a certain period called the ‘lock-in period’. No exit charges apply if you redeem your units after the lock-in period. For instance, say, if a fund is priced at Rs.500 and the investor is looking to redeem within the lock-in period, then he has to pay an exit load of Rs.5 for every unit he redeems if the exit load is 1%.

Differences between Mutual Funds and ETFs

There are several differences between mutual funds that are important to know before choosing one over the other for a particular investment strategy or goal. Mutual funds have some advantages over ETFs while ETFs are smarter investment tools for some objectives. Some differences are significant while others are subtle.

Here is a quick summary of the differences between mutual funds and ETFs, followed by more detail:

• Mutual funds trade at the end of the day, while ETFs trade intra-day.
• Stock orders can be made with ETFs but not with mutual funds.
• ETFs often have lower expense ratios than mutual funds.

The primary difference between mutual funds and ETFs is the way they trade (how investors can buy and sell shares). What does this mean? For example, let's say you want to buy or sell a mutual fund. The price at which you buy or sell isn't really a price; it's the Net Asset Value, or NAV, of the underlying securities; and you will trade at the fund's NAV at end of the trading day. Therefore, if stock prices rise or fall during the day, you have no control over the timing of execution of the trade.

For better or worse, you get what you get at the end of the day with mutual funds.

In contrast, ETFs trade intra-day. This can be an advantage if you are able to take advantage of price movements that occur during the day. The key word here is IF. For example, if you believe the market is moving higher during the day and you want to take advantage of that trend, you can buy an ETF early in the trading day and capture its positive movement. On some days the market can move higher or lower by as much as 1.00% or more. This presents both risk and opportunity, depending upon your accuracy in predicting the trend.

Part of the trade-able aspect of ETFs is what is called the "spread," which is the difference between the bid and ask price of a security. However, to put it simply, the biggest risk here is with some ETFs that are not widely traded, where spreads can be wider and not favourable for individual investors. Therefore look for broadly traded index ETFs, such as SPDR S&P 500 (SPY) or iShares Core S&P 500 Index (IVV) and beware of niche areas such as narrowly traded sector funds and country funds.

Another distinction ETFs have in relation to their stock-like trading aspect is the ability to place stock orders, which can help overcome some of the behavioural and pricing risks of day trading. For example, with a limit order, the investor can choose a price at which a trade is executed. With a stop order, the investor can choose a price below the current price and prevent a loss below that chosen price. Investors do not have this type of flexible control with mutual funds.

ETFs typically have lower expense ratios than most mutual funds and can sometimes have expenses lower than index mutual funds. This can in theory provide a slight edge in returns over index funds for the investor. However ETFs can have higher trading costs. For example, let's say you have a brokerage account at Vanguard Investments. If you want to trade an iShares ETF, you may pay a trading fee of around $7.00, whereas a Vanguard index fund tracking the same index can have no transaction fee or commission.