A Mutual Fund is a common ('mutual') pool of money ('fund') managed by a Fund Manager (an individual or a team). It is a great way for individual investors to get easy access to professionally managed and well-diversified portfolios of stocks (equity) and bonds (debt).
When you invest in a Mutual Fund, you are giving your money to a Mutual Fund Manager to invest it according to the guidelines laid out in the Mutual Fund's prospectus (for e.g. a large cap equity fund will invest in the biggest listed companies on the stock exchange).
The Mutual Fund Company is providing you a service
- investing your money professionally - and it charges you for it.
There are broadly 3 kinds of charges that you will incur while investing in Mutual Funds:
1. Fund Management Fees or 'Expense Ratio'
Your Mutual Fund manager and his team need a salary to work for you and there are a host of other operational costs involved in setting up and running a Mutual Fund. All these costs are clubbed together as fund management fees and are charged as a percentage of the money being managed (hence also known as the Expense Ratio). A common way to express it is as a percentage per year e.g. 2% per annum .
The Mutual Fund tries to make up for these charges by generating higher returns for its investors (not all may succeed though).
Important things to know about Mutual Fund Management Fees (Expense ratio)
The management fees (Expense Ratio) varies from fund to fund - for equity funds it is generally in range of 2-2.5% and for debt funds, the range is usually lower - about 0.1-1%.
The management fees is deducted daily - The management fees although spoken of as an annual percentage is actually deducted on a proportional pro-rata basis daily i.e. if the expense ratio is 2% then roughly 2%/365 will be deducted daily.
The management fees is deducted daily for as long as the money stays invested - Because it is a management fees, it is charged on the entire money invested and for as long as it stays invested. That is, if you invest Rs 1 lakh today and keep it invested for 5 years - you will be charged management fees by the Mutual Fund every single day.
Regular (Distributor) vs Direct: When you buy Mutual Funds through a distributor like Goalwise (as opposed to directly from the Mutual Fund's website), then you get Regular Mutual Funds where your expense ratio is higher as it also includes the commission paid by the Mutual Fund company to your distributor (i.e. to Goalwise). This commission is usually ~ 1% per year for equity mutual funds and ~ 0.1% per year for debt mutual funds. This is the fees you indirectly pay your distributor for its services like advisory, planning, convenience etc. (You can see our commissions here).
The Mutual Fund NAV is published after deducting the management fees - The NAV and returns that you see in your account statements (and Goalwise dashboard) already have the expense ratio (inclusive of any distributor commissions) subtracted from them i.e. you get what you see.
Cheaper is not always better - What matters is the net returns that you are going to get. So if the more expensive fund is generating higher net returns it is better than the cheaper but lower net returns.
2. Exit Load
Exit load is like a penalty for a too-soon withdrawal of funds. Mutual Funds usually do not have lock-ins but they do charge you for very quick withdrawal of funds. Not all funds have it but it is fairly common in equity funds. Also, the length of time considered as too-soon is mostly uniform for equity funds at 1 year but varies greatly for debt funds.
It is only applicable when you sell your Mutual Fund units 'too soon'.
Equity funds: 1% of the total amount being withdrawn within 1 year of being invested is deducted. If the units are held for more than 1 year, then no exit load is applicable.
Debt funds: For Short Term Debt funds, it is usually nil; for Medium Term Debt funds it may be nil or have a very short applicable period e.g. a week to a month. For Long Term Debt funds it is usually 1% and the applicable period ranges from 6 months to an year.
You can run but you can't hide. Well, may be you can if you own some cool Panama hats but for the rest of us, taxes are a certainty. But there is good news. Mutual Funds are probably the most tax efficient investment options out there for both equity and debt.
The biggest component of Mutual Fund taxation is the Capital Gains Tax (the tax on profits) which is discussed below. There are some other taxes as well like STT and Dividend tax which are covered in a more detailed post here.
Capital Gains Taxes are applicable only when you sell and only on the gains made on the units being sold.
For Resident Indians, the tax is NOT deducted by the Mutual Fund. Tax is to be paid by you before the financial year ends on your own. For NRIs, the Mutual Funds will deduct the tax (TDS) from the investments when you withdraw the money.
Capital Gains Taxes depend not only on amount of gains but also on the type of investment (equity or debt) and the length of time the investment is held for (short term or long term). See the summary table below.
LTCG in stocks and equity Mutual Funds upto Rs. 1 lakh in a financial year will be free of tax. LTCG Tax at 10% will only apply to equity LTCG beyond Rs. 1 lakh at a PAN level for a financial year.
Indexation means after subtracting inflation from your overall returns i.e. if overall returns are 8% and inflation is 7% then tax applicable is 20% of (8%-7%) = 20% of 1% = 0.2%.
Debt Mutual Funds are 10 times more tax efficient than Fixed Deposits while providing similar safety and returns because of indexation benefits. In FD all gains are taxed at your current income tax level irrespective of how long the FD was kept for. So in this example if you are in the 30% bracket, your tax applicable would be 30% of 8% i.e. 2.4% - more than 10 times than that of debt funds!
[Advanced stuff] In case of losses in one investment, a tax deduction can be claimed for profits in another investment. These deductions can also be carried forward to be offset against future gains, if and when they happen. (This is an oversimplified version of taxation of losses - you can ignore it for now, you will know when you need it).
Whenever you consider selling your investments, take into account these costs or they could eat into your returns. More reasons to stay invested for the long-term. :)