Is your fund leaking too much?

Well, yes. Good performing funds pay out dividends and give capital growth. But that is after they have deducted their expenses from the corpus. Every year, even when the fund loses money, it charges the fund the expenses for managing the fund. These expenses are deducted from the total corpus even before the price or the Net Asset Value NAV is worked out. The price at which you buy and sell, is net or, or after the expenses each year have been built in.

We don8217;t need to get into finding out how the fund calculates its expenses and what it includes in this calculation, what matters to us here is the final impact. This is encapsulated in a number called the 8216;expense ratio8217;. An expense ratio of 2 per cent means that Rs 2 out of every Rs 100 you have invested is deducted for running the fund, each year. This is not a one time deduction, like a front end load that you pay one time when you buy a fund, but an annual charge. Something like what your demat company or your credit card company charges you. Except that in this case, it is a percentage of your investment and not a flat fee. Put in Rs 5 lakh and at 2 per cent you are paying Rs 10,000 every year to the fund to manage your money.

Expenses vary across fund types
Typically debt funds cost less than equity funds since the costs of stock selection and research are higher in an actively managed not a passive fund like an index fund equity fund as compared to a debt fund. But debt funds are more sensitive to this expense, since their returns are lower. An expense ratio of 2 per cent in a fund that returns 5 per cent typically a debt fund will pull down the cost-adjusted return to 2.9 per cent, whereas the same cost in a fund that returns 15 per cent typically an equity fund will pull down return to 12.7 per cent. The investor in the first fund will hurt more than the investor in the second, due to this cost, specially if inflation is between 3 to 5 per cent.

It is important to know the different average expense ratios in the industry today. Value Research calculates that short term debt funds cost an average of 0.79 per cent, the average debt fund costs 1.3 per cent per annum and an average equity fund costs 2.02 per cent. International averages are are much lower at 0.18 to 2 per cent. This is a function of large volumes and competition making funds reduce their costs. Indian funds are still some way away from such low expense ratios due to their smaller size. Index funds, that cost as little as between 0.18 per cent to 0.25 per cent since they are not actively managed and only mimic the index they follow, cost much more in India at about 1 per cent. Compare the average return of the fund type before you buy.

But high cost does not mean high return
It is a myth that more expensive the fund, the better the performance see chart. The low expense funds have done equally well as the high cost funds. In fact the US market watchdog the Securities Exchange Commission SEC writes on its website: 8220;Higher expense funds do not, on average, perform better than lower expense funds.8221; So, don8217;t get taken in by marketing hype that justifies high costs by performance.

This is not to say that mutual fund costs are unfair or should be banned. Mutual funds bridge a very important gap between the market and the average investors who may not have the knowledge or the time to invest. Since funds are not in the business for charity, it is only fair that they should charge for this service. You should pay, but you should be aware that you are paying and how much you pay should become an important variable in fund selection. Look not just at return but also at what it costs you each year to get that return.