How to maximize the returns of your Mutual Funds

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I am sure that a lot of you think that your financial advisor / manager / agent who recommends mutual funds to you are doing so free of charge and hardly benefit from this recommendation. This is a big misconception. You are in fact paying a really large amount without even realizing it.

Let me introduce the concept of Expense Ratio to you. This expense ratio is what you pay your agent and the mutual fund house to invest in the mutual fund. You may not realise this expense because the fund houses and agents don’t take a yearly cheque from you for the same. If they did you would be a lot more conscious about this cost. This amount gets deducted automatically from your returns. Most investors either don’t realize this cost exists or think that this amount is too small to worry about. Hopefully by the end of this blog post i’ll end up changing your mind about expense ratios.

Expense ratios can destroy your returns

This typically ranges from 1.5% to 3% of your investment. These numbers may sound small at first glance, however keep in mind that these numbers apply to your entire investment amount i.e principal + interest. So if your fund manages a 15 percent return (prior to expenses) you will end up making a 12% return instead of 15%. Read about the Power of Compounding here to get a better understanding the difference between 12% vs 15% returns over the long term.

You are paying these fees regardless of how your fund performs

Let’s say you invest Rs 1,00,000 lumpsum in a mutual fund and after the 1st year the underlying stocks remained exactly the same in price, you would end up losing Rs 3000 (if the expense ratio is 3%) and the new value of your fund is now Rs 97,000 instead of Rs 1,00,000. You need to pay these expenses year after year even if your funds do not perform.

It’s not true that higher fees will give you better performance

Financial advisors argue that you get what you pay for and that you will make much higher returns on funds that have a high expense ratio. In fact the reality is exactly the opposite . These high expense ratios end up eating a lot of your returns and over a 15+ year period funds with low expense ratios tend to outperform those with high expenses. This is why Index funds have become so popular in the US and are now slowly catching up in India. Read more about Index funds In India here

Expense Ratios are a lot worse than Tax

We all took notice when the government introduced Long Term Capital Gains Tax (LTGT). However that’s only a one time tax of 10% on the final profit of your equity investment.  You are paying much more on expense ratios without even realizing it.
Let’s say that your fund has a 3% expense ratio and for manages to generate a 20% return prior to expenses every year. You will end up making a return of 17% instead of 20%. That’s equivalent to paying 15% tax every year (3/20*100) . The government charges you 10% LTCGT one time on your final profits after you sell your mutual fund however the mutual fund houses charge you 15% every year. Shouldnt the Fund house’s charges annoy you more than the government’s Tax? These charges are ridiculously high yet very few people are even aware and concerned about it.  Also remember that you need to pay these fees even if your fund does not perform!

You can reduce these expenses by going directly to the fund house

You can reduce your mutual fund fees (expense ratios) by nearly half by going directly to the fund house. Fortunately SEBI has mandated mutual fund houses to disclose the expense ratios so that investors know exactly how much they are paying. There are 2 plans that all Fund houses offer to investors
1. Regular and
2. Direct

 The only difference between these plans is that the Regular plan has nearly double the expense ratio compared with the direct plan. The difference between the Regular and Direct expense ratio is what is paid as commission to your agent / advisor. They have a direct incentive to recommend funds that have high expense ratios.

Now that you are aware of this difference I highly recommend you start going directly to the mutual fund website and invest directly.  You will save a large amount of money and is definitely worth the few additional minutes that it requires. 

How to Check Expense Ratios for your Mutual Fund

I usually go to Valueresearchonline.com and search for my fund. Below are some screenshots that show you want to look for

 

 

 

Difference in Performance Between Regular and Direct Plans

Just incase you are not yet fully convinced go through the below tables to understand the true cost of Regular plans. Let’s say you make an initial investment of Rs 5,00,000 (5 lakhs). The below tables shows you the final returns for a Regular plan and a Direct Plan at a 15%  pre-expense return.

15% returns with a 3% Expenses Ratio (Typical Regular Plan)

YearExpected Interest RateExpense RatioAmountAmount in words (Rounded)
015%3%5,00,0005 Lakhs
515%3%984,930 10 Lakhs
1015%3%19,40,17719 Lakhs
2015%3%75,28,58075 Lakhs
3015%3%2,92,13,568 2 Crores 92 Lakhs
4015%3%11,33,59,03711 Crores 33 Lakhs

15% returns with a 1.5% Expenses Ratio (Typical Direct Plan)

YearExpected Interest RateExpense RatioAmountAmount in words (Rounded)
015%1.5%5,00,0005 Lakhs
515%1.5%9,95,25110 Lakhs
1015%1.5%19,81,05120 Lakhs
2015%1.5%78,49,129 79 Lakhs
3015%1.5%3,10,99,0603 Crores 11 Lakhs
4015%1.5%12,32,17,68012 Crores 32 Lakhs

 

Notice the difference in the final amounts over a 40 year duration. The Direct plan makes you 1 core more than the Regular plan. You are paying Rupees 1 core (12,32,17,680 – 11,33,59,037) over 40 years to your fund advisor (and you thought you were getting advice for cheap) and getting back little in return.

By design the financial planner’s interests and that of their clients are in opposition. There is far more money to be made selling expensive investments than there is in simple low-cost efficient ones. To do what’s best for the client requires the advisor to do what is not best for himself. It takes a rare and saintly person to behave this way. Money management seems not the calling of the rare and saintly.

I hope you decide do your own research and manage your own money. Move your mutual funds to a direct plan once you feel confident and save yourself a lot of money.

 

2 thoughts on “How to maximize the returns of your Mutual Funds

  1. Sir,
    I have accumulated 50 Lakh from regular schemes and my my current SIPs are 40K. Kindly let me know how much tentatively I would save if I choose direct route. Agent commission will be saved from new direct SIPs or from already accumulated corpus ? Thanx.

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