The utility that mutual funds can offer to investors has been discussed and often eulogised in great detail. However, there is another vital aspect to mutual funds that is rarely spoken about -- the costs.

Investing in mutual funds entails bearing certain costs on the investor's part. These costs, in turn have an impact on the returns clocked by the investor. In this article, we take a closer look at the various costs and expenses borne by investors while investing in a mutual fund scheme.

1. One-time charges

Entry/exit loads and initial issue expenses qualify as one-time charges, as opposed to recurring expenses which have been dealt with later in the article. First, let's consider the case of new fund offers (NFOs). Over the last few years, investors have been faced with a deluge of NFOs. But in recent times, a perceptible trend in NFOs has been a rise in the number of close-ended funds.

This phenomenon can be traced to the rules governing initial issue expenses. Close-ended funds are not permitted to charge any entry load; instead 6% of the sum mobilised during the NFO period can be utilised to meet the initial issue expenses. The same can be amortised (charged to the fund) over the fund's close-ended tenure.

For example, if a close-ended fund were to mobilise Rs 500 crore (Rs 5 billion) during the NFO period, the asset management company (AMC) can utilise Rs 30 crore (Rs 300 million) to meet the sales, marketing and distribution expenses. Furthermore, the stated sum will be charged to the fund. This will impact the returns clocked by the fund. Any amount over the stated 6% has to be borne by the AMC.

Conversely, in the case of open-ended NFOs, funds are required to meet all the sales, marketing and distribution expenses from the entry load. They are not permitted to charge any initial issue expenses. The rules governing entry/exit loads state that taken together, the two cannot account for more than 6% of the net asset value (NAV).

Charging an entry load for the entire 6% upfront would adversely affect the fund's performance in the initial period. Hence AMCs choose to have rather "rational" entry loads in the range of 2.25%-2.50%. Like initial issue expenses, entry loads also eat into the investor's returns, since the investor has that much less money working for him.

For example, say an investor invests Rs 5,000 in an open-ended fund that charges an entry load of 2.50%. Effectively, only Rs 4,875 is invested in the fund.

It is not difficult to understand why AMCs have a newfound liking for close-ended funds. With the provision for charging 6% of amount mobilised towards initial issue expenses, AMCs are better equipped to compensate the distributors and agents, who in turn help the fund houses in accumulating more assets.

Higher assets translate into higher revenues for the AMCs. Of course, close-ended funds do offer advantages as well. For example, the fund manager can make investments from a long-term perspective and investors are given the opportunity to invest for a pre-defined investment horizon. However, investors would do well to factor in the costs involved.

2. Recurring expenses

Investors also have to contend with recurring expenses, which are charged annually to the fund. These expenses are revealed in the form of an expense ratio that is declared twice a year.

Recurring expenses (as is the case with amortised initial issue expenses) are "silent" in nature since they don't necessarily attract the investor's attention. The reason being that the fund's NAV is declared after the recurring expenses have been accounted for.

The Securities and Exchange Board of India (Sebi) has laid out guidelines defining the manner in which recurring expenses can be charged; the same is a factor of the fund's average weekly assets (however most AMCs choose to compute it as a percentage of the average daily assets).

As can be seen from the table above, the grid for recurring expenses has been structured in a manner to ensure that the expenses charged to the fund reduce with an increase in the asset size. The recurring expenses include marketing and selling expenses (including agents' commission), brokerage and transaction costs, custodian fees and fund management expenses (paid to the AMC), among other expenses.

A typical list of recurring expenses for an equity fund would look like the following:

The expense head which merits attention is "fund management"; this represents the AMC's revenue stream. In other words, the salaries and other compensation offered to the fund management team is charged to the mutual fund scheme under this head. Sebi guidelines explicitly state the manner for computing fund management charges and limits for the same.

As can be seen from the grid, the AMC's revenue is directly proportional to the mutual fund scheme's asset size. Hence the incentive for accumulating a sizeable corpus! For example, consider the case of an equity fund with an asset size of Rs 1,000 crore (Rs 10 billion). The AMC could charge up to Rs 10.25 crore (Rs 102.5 million) to the mutual fund scheme towards fund management charges.

Do expenses really matter?

Having discussed the various costs and expenses involved while investing in a mutual fund scheme, let's now find out if they really matter. To understand this better, we shall compare two mutual fund schemes, one with a low cost structure (say Fund A) and the other which isn't quite as charitable (say Fund B). Investments in Fund A attract an entry load of 1.0%, while the number is 2.5% for Fund B.

Similarly, the recurring expenses are 1.5% and 2.5% for fund A and fund B respectively. Assume that Rs 100,000 (one-time investment) is invested in each fund for a 10-year period and that both the investments grow at 15.0% per annum.

On maturity (i.e. at the end of 10 years), the investment in fund A would be worth Rs 344, 331, while that in fund B would be worth Rs 306, 217. The differential can be traced to Fund A's cost effectiveness.

While evaluating a mutual fund scheme, factors like the AMC's investment philosophy and style, track record across parameters (risk and return) are usually given due weightage. To that list, investors would do well to add the fund's cost efficiency. After all, as we have observed, over the long-term the costs involved can have a significant impact on the fund's performance.

By Personalfn.com, a financial planning initiative. It can be reached at info@personalfn.com. Personalfn.com also publishes a free-to-download financial planning guide, Money Simplified. To get a copy of the latest issue - How ULIPs fit in - please click here.