Charges cost you dearly

“You will be surprised at the difference it can make,” I replied. “Let us say that you have Rs 3 lakh to invest. You decide to subscribe to an investment product that will invest in equities. There are two options available to you. The first is a low-cost fund that will charge you 1 per cent per annum. The second is a high-cost fund that will charge you 2.25 per cent per annum. The high-cost fund is able to spend more on advertising and distribution costs. As a result,you see more bill-boards and advertisements. These have made you familiar with the name of this high-cost fund. Since you believe that costs are immaterial,you would choice the high-cost fund.

“Of course,” Chetan replied.

Let us assume that both funds give the same return of 15 per cent per annum for 10 years. In the table below is shown the value of the Rs 3 lakh that was invested:

As can be seen,at the end of 10 years,Chetan will receive over a lakh of rupees less than an investor in the low-cost fund. Chetan was shocked.

“So I am paying the fund more than Rs 1 lakh for their overheads?” asked Chetan.

“That is correct,” I replied.

“I had no idea that I had to pay such a large amount to the fund. I must choose a fund that has lower expenses. It seems very easy to compare the fund charges. Is it really that easy?” asked Chetan.

Different kinds of charge structures

“Not quite,” I replied. Each investment product has a different cost structure. The total cost described as “charges” includes various components such as premium allocation charges,administrative charges,management charges,transaction charges,and so on. An investor has to bear all these charges. Therefore,before you invest,you must find out the total cost that an investor has to pay irrespective of the name of the charge. Further,some instruments such as Unit Linked Insurance Plans (ULIPs) have varying charges for different years. For example,the policy allocation charge for a ULIP may be 20 per cent for the first three years,then say 5 per cent for the next three years and then it will come down to 2 per cent for the remainder of the term. These complicated structures make comparison across products very difficult for the lay investor.

ULIPs will also levy a charge for the insurance cover that they provide. This insurance is provided by deducting a “mortality charge” from the premium paid. Below is a simplified comparison of a ULIP-like product and a mutual fund. Since we are comparing only the investment components of the two instruments,mortality charges have not been considered. Further,for simplicity,all other charges such as fund-management charges have not been considered. The ULIP-like product has cost the investor about Rs 5 lakh over the 10-year period (see table below)

Know the costs before investing

The cost of an investment product is important. An investor must do his own cost calculations before favouring a ULIP,mutual fund or any other investment product. It is possible that an investor may choose a higher-cost product for the convenience it offers. But he should do so knowingly. Chetan understood the importance of costs and concluded that his friend Sachin was right.

“Shouldn’t the government ensure that all products have a similar cost structure to help investors choose?” Chetan said. I smiled. The government cannot spoon-feed every investor. If something comes out of the recent spat between Securities and Exchange Board of India (Sebi) and IRDA,we could see ULIP charges also getting aligned with those of mutual funds.

This will help investors like you compare products on a cost basis more effectively. It was now Chetan’s turn to smile. Our breakfast was over. Both of us said our goodbyes and left.

The author,Veer Sardesai,BE,CFP™,MBA (IU,USA) is the chief executive of Sardesai Finance. ceo@sardesai.com