Mutual fund expenses - how are these calculated and charged?

How are mutual fund expenses charged? Do I pay both at the time of entry and exit? In such a case, does it not become costly? There are many questions around the fund expenses. Read on for the answers

http://epaper.gujaratimidday.com//epaperpdf/gmd/03072017/03072017-md-gm-12.pdf

The English translation is as under:

Understanding mutual fund expenses

We have already covered the expenses charged for the management of a mutual fund scheme in one of our earlier articles. Mutual fund companies are allowed to levy only two types of charges, viz., (1) exit load – chargeable at the time of investor’s exit from the scheme in certain schemes only if the exit is within a stipulated period of time, and (2) fund expenses – chargeable to meet expenses and payment of fees to various constituents.

We will elaborate on the second in this article today.

There are various constituents working to make the mutual fund run professionally in the best interests of the fund’s investors. These constituents need to be paid their fees for the services provided. This fee is payable through charging each scheme a certain percentage of the fund’s corpus.

These expenses are mentioned in terms of percentage of the scheme’s AUM (Assets Under Management) or the scheme’s corpus. SEBI regulates the maximum expenses that can be charged to the scheme.

These expenses are mentioned as annualized percentages with respect to the scheme’s AUM, but charged on a daily basis such that the scheme’s NAV accounts for the expenses on a daily basis. Let us understand the nature of these expenses with a calculation.

Let us say, a scheme’s corpus is Rs. 1,00,000 and the expenses are 2% p.a. In such a case, the expense charged for the day would be as under:

Expense charged for the day = Scheme’s corpus X fund expenses (% p.a.) / 365

In the example given,

Expense charged for the day = Rs. 1,00,000 X 2 % p.a. / 365

                = Rs. 5.48

If the scheme corpus goes up the next day, a higher amount would be charged for that day. At the same time, if the scheme corpus drops, the expenses charged would be lower. Taking the calculation further, if the scheme’s corpus goes up to, say Rs. 1,10,000 the next day (corpus can change on account of change in the market prices of the securities as well as fresh inflow by investors or redemptions or payment of dividends).

Expense charged for the day = Rs. 1,10,000 X 2 % p.a. / 365

                = Rs. 6.03

On the other hand, if the corpus had falled to Rs. 95,000; the expenses charged would reduce.

Expense charged for the day = Rs. 1,10,000 X 2 % p.a. / 365

                = Rs. 5.21

If someone stayed invested only for three days and then took the money out, the expenses charged would be only for the three days that one stayed invested. Also please note that this is not charged at the time of entry or exit, but on a daily basis. Thus, the expense is charged fairly to all fund investors in proportion to the amount invested as well as their stay with the fund.

Hope this clarifies some doubts that one might have.

How is the NAV of a mutual fund scheme calculated? Do the inflows and outflows in the scheme impact the NAV?

The other day, in an investment seminar someone asked a question: “How is the NAV calculated?” He also wanted to know if the daily inflows and outflows in the fund by investors impact the NAV calculations apart from the movement in the prices of securities held by the fund.

Read my article in Mid-day Gujarati edition today to understand the NAV calculation:

Mutual Fund NAV calculation

The other day, in an investment seminar someone asked a question: “How is the NAV calculated?” He also wanted to know if the daily inflows and outflows in the fund by investors impact the NAV calculations apart from the movement in the prices of securities held by the fund.

Let us look at both parts of the question and answer each. First of all, what exactly is NAV in the context of a mutual fund?

NAV is the Net Asset Value of the fund – popularly mentioned as NAV per unit. In the accounting parlance, NAV is the other name for book value. This is the value of the scheme’s total assets less the liabilities. If you simply add up all the assets and deduct all the liabilities of the fund, you get the value of the net assets. Divide this by the number of outstanding units and you get the NAV per unit.

NAV per unit = (total assets of the scheme – total liabilities of the scheme)

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                    Number of outstanding units

This looks simple. Having reached till here, we need to understand what the fund’s assets and liabilities are.

A mutual fund scheme invests in many securities as per the investment objective. We have discussed this earlier. The market value of these securities (or investments) forms the major part of the fund’s assets. Apart from that there are some minor contributors, e.g. interest accrued but not received, dividend declared but not received yet, proceeds receivable on sale of investments, money parked in money market instruments and bank balance. All these are examples of the fund’s assets. The value of investments has to be taken as the current market price, which is an indicator of the realizable value of the scheme’s assets.

Now come the liabilities. We saw earlier that a mutual fund cannot borrow money for the purpose of investing. The only exception allowed is when the fund has to meet redemptions or dividend payouts and is unable to liquidate the investments due to some critical factors like a market meltdown or illiquidity in the system. Such a liability, if exists, should be added to the fund’s total liabilities. At the same time, there are some liabilities that exist on a regular basis. These are fees payable to various constituents like the asset management company, the custodian, bankers, R & T agent, directors, auditors, distributors, etc. there could also be liability on account of payment to be made for securities purchased. All the liabilities get added up and these have to be deducted from the fund’s assets.

As mentioned earlier, this would give the net assets of the fund.

Dividing this by the number of outstanding units would give the NAV per unit. This NAV has to be calculated on a daily basis. The accounts students among the readers can easily make out that in order to arrive at the fund’s net assets, the scheme’s balance sheet must be prepared. Since the NAV is calculated on a daily basis, the balance sheet is also prepared daily. Which business would be preparing final balance sheet daily? This is another example of the transparency of a mutual fund.

This answers the first part of the question – regarding the calculation of NAV.

Now let us consider the second part of the question. “Do the daily inflows and outflows impact the NAV of a scheme?” as you can see in the answer to the first question; the inflows and outflows into or out of the scheme do not feature in the NAV calculation. However, many keep asking if these inflows and outflows have any impact on the scheme’s NAV.

Well, the short answer is “no, they do not impact the NAV on a daily basis.” However, this is a simplistic answer and only looks at the theory. It is also important to check whether these have any impact on the NAV, at all.

When an investor purchases the units of the scheme, there is an inflow of money in the scheme. The scheme allots units at the prevailing NAV. This is the NAV that has been calculated as discussed earlier. The investor, who submits the purchase application before the cut-off time, gets units at the NAV calculated based on the closing prices for the day. Exactly same process is followed when an investor takes money out of a scheme.

As can be seen, the inflows and outflows do not impact the NAV.

However, when a scheme receives huge inflows in relation to its corpus, the fund manager may not be able to invest all the money immediately. This means, cash would be held in the portfolio for a considerable amount of time. This impacts the future NAV changes since cash and securities may not move together.

This is a small point that must be kept in mind. At the same time, since short term price movement is unpredictable and there is an (almost) equal probability that the prices may move up or down in the short run, this impact may get cancelled out over the years.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

Not defining a goal likely to land you in a financial mess

Yesterday Portugal won the EUFA European Championship 2016 by defeating France in a close encounter. The final score read 1 - 0. While we still have good memories of the matches that were played between some great players of recent time, here is a write up regarding one very important lesson we can learn from football and apply in our financial lives.

Click on the link below to read the article:

Not defining a goal likely to land you in a financial mess

Questions on investments answered

Click on the link below to read the transcript of the chat on www.moneycontrol.com:

Equity investments simplified

Are debt funds totally safe?

Are debt funds totally safe? Or do they carry some risk? Click on the link below to read my article in Mid-day Gujarati today.

http://epaper.gujaratimidday.com//epaperpdf/gmd/11072016/11072016-md-gm-13.pdf

The English translation is as under:

Debt mutual funds – are they totally safe?

Is there a mutual fund option for someone, who does not want to take any risks? Well, there are many investors that keep asking this question. Very often, they also think that only equity funds are risky and that there is no risk in debt funds. Since debt funds invest in debt securities, these funds are exposed to the risks associated with such securities.

Today we will discuss a very important risk related to debt securities and other fixed income investments. In the language of investments, this risk is known as the default risk or credit risk. This risk is strongly associated with debt securities and other fixed income investment options.

As we understand, when someone invests in a debt security, i.e. a debenture or a bond or a similar instrument, e.g. a fixed deposit, one is lending money to someone in need of it. In case of debentures, bonds and fixed deposits, the borrower would generally be a company, a bank or a Government.

The borrower is required to pay interest to the lender, i.e. the investor. This interest is the income for the investor. This interest payable is agreed upon right in the beginning, along with the time schedule of the payment.

However, there is a possibility that the borrower may not return the money in time. This possibility is known as the default or credit risk. Such a risk is inherent whenever the borrower is anyone other than the government of the investor’s country. The risk, simply stated, is the possibility that the borrower does not pay up the dues as per the agreed schedule. The key phrase here is “as per the agreed schedule”, which means both non-payment and delayed payment are covered.

There are two factors leading to this risk – the ability and the willingness of the borrower. While willingness is difficult to measure, the ability can be measured through the financial statements, especially in case of a company. This is done by the credit rating agencies and they assign credit rating to the various debt papers issued by the borrowers for the purpose of lending. Please remember, the rating is assigned to a paper and not to the issuer.

Between short term and long term borrowing, one may consider the long term borrowing to be riskier as the uncertainties rise with the increase in the term of borrowing. Similarly, if the borrowing amount is small, the ability is higher than if the same is large. Companies may also issue debentures backed by the security of asset. Such secured debentures may enjoy higher rating than an unsecured paper issued by the same issuer.

Though credit rating could be a good starting point to evaluate whether to invest in certain debt papers, the risk does not completely go away even with the highly rated papers. The risk keeps rising with the drop in credit rating. A proven and time-tested method to reduce such risk is to diversify across various issuers. The ability to repay is less likely to suddenly drop across different companies operating in different businesses and industries.

This risk is present in all debt securities, as already mentioned earlier. The only issuer that is considered to be free of this risk is the government of a country, since it is authorized to print currency in case the need arises. For any other entity, the risk is higher than zero.

Debt mutual funds invest in debentures, which carry this credit risk. Hence, the debt fund investors are also exposed to this risk, indirectly. If a debenture in which a debt fund has invested defaults, i.e. does not return the money in time, the NAV of the debt fund would drop to that extent.

However, there are two major reasons that reduce this risk for debt funds:

1.     A professional fund management team evaluated which securities to invest in. being a professional, the fund manager is likely to do a better job than most individual investors.

2.     By regulation, the debt fund portfolio needs to be diversified across issuers. As we discussed earlier, diversification also reduced the risk of default.

Apart from that, an investor can evaluate which schemes to invest in based on (1) the investment objective as defined in the offer document and (2) the portfolio as disclosed in the monthly fact sheet of the fund.

A very important piece of information in the fact sheet is the rating profile of the fund, which shows how much is the scheme’s exposure in what type of credit rating. If the investor is uncomfortable with high exposure in lower rated papers, one may avoid the scheme altogether.

Debt funds, though not risk free, are a great way to invest for the conservative investor, as the risk of default is managed through professional fund management and diversification.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

Winning mantra in amateur investing

With the Wimbledon final approaching, I thought of sharing this article I had written little over a month back. Enjoy reading ...

Avoid unforced errors: winning mantra in amateur investing

33 years ago, on this day, we made history ...

Exactly 33 years ago, around this time, many Indians were quite nervous. This was their date with destiny and the meeting was scheduled in the afternoon at the Mecca of cricket, the Lords cricket ground. The occasion was the final of the 3rd Prudential World Cup of cricket. It was a final match between the minnows - the Indian team - Kapil's devils and the mighty superpower of cricket and the title holders West Indies led by Clive Lloyd. While reaching the finals was unthinkable for the Indians, what they were about to face was a wounded lion. India had beaten WI once in the tournament on the road to the finals. Incidentally, just before the world cup, Indians were visiting the Caribbean Islands and had defeated them in a ODI match at the Indians' favourite venue the Port of Spain.

In the finals, the Indians were to bat first and could put up a paltry 183 all out on board. West Indies required to score 184 in 60 overs match to retain the trophy.

What happened afterwards, is HISTORY.

Well, here is an article I wrote in 2011 quoting the significance of this win. How such a match help us understand the concepts of personal finance. Click here to read the story.

It is important to understand the nature of investment and the risks associated before thinking of taxation

The other day I received a query from someone. This person was advised to invest his money in fixed income funds since the money was needed in around two years’ time. He wanted a second opinion.

His question was: “Should I not look at equity funds since the returns on fixed income funds would be taxable, whereas capital gains on equity funds after a holding period of one year would be exempt from long term capital gains tax. Similarly, I can also opt for dividend option, too as dividends are also tax-free.”

Here is my article published in Mid-day Gujarati today


The English translation is as under:

Should you invest in equity funds since these are more tax-efficient?

The other day I received a query from someone. This person was advised to invest his money in fixed income funds since the money was needed in around two years’ time. He wanted a second opinion.

His question was: “Should I not look at equity funds since the returns on fixed income funds would be taxable, whereas capital gains on equity funds after a holding period of one year would be exempt from long term capital gains tax. Similarly, I can also opt for dividend option, too as dividends are also tax-free.”

He quoted an oft repeated line “It is not what you make, it is how much you take home after taxes that counts”.

He was also convinced that equity funds have potential to offer higher returns that fixed income funds.

This combination of potential higher returns coupled with lower (zero, in this case) tax makes equity funds appear far superior to fixed income funds.

Both the arguments in favour of equity funds are right – potential for higher returns and that the tax-efficiency is far superior. What is missing here is the risk involved. The risk is very high that even a well managed and well diversified portfolio of equity shares may lose value periodically. Though such drops in value may be temporary, they do exist and sometime for long periods of time.

It is this risk that should be considered first before worrying about paying taxes. Many investors make this mistake of looking at the taxation first. This results in highly tax-efficient but sometimes highly risky portfolios. It is not just in case of equity, we have seen this fascination towards saving tax in many other areas of personal finance. However, we shall restrict our discussion in this article only to the question we started with.

While equity funds have the potential for providing higher returns than fixed income funds, such a statement is more likely to be true if the holding periods are long. The price fluctuations in the short term would render the fund vulnerable. One is likely to experience a highly volatile NAV in case of an equity fund as compared to a fixed income fund.

These fluctuations may result into a situation that the value of investments could be lower when one needs money. Our investor had a need for taking money out of investments in around two years.

To answer the investor above, what he was advised was the correct investment option. With a two year investment horizon, it is prudent to invest in fixed income funds. To put it another way, it would be too risky to consider investing in equity funds if the investment horizon is two years.

Consider the nature of investment first – the risk involved before you look at the taxes.if the value of the portfolio is down at the time of redemption, there would be no taxed, anyway. It is often better to pay taxes on investment income than to see a situation when the investment loses money.

Use equity funds for your long term needs and fixed income funds if the need is short term in nature.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.