Avoid Mutual Funds with Hidden Costs and increase the chances of earning index-beating returns. 

We all are quite familiar about mutual Fund expense ratio and we rightly desire that it reduces as much as possible. Recent circular of SEBI have furthered lowered the cap on mutual fund charges in a regular plan. Growing popularity of Direct Plans further catalysed by PayTM’s entry into selling Mutual Funds is a testimony to the importance of costs when investing through mutual funds.

But how many of us realize that there are costs which are not visible in the expense ratio that impact the returns that we earn in Mutual Funds?

What are these ‘hidden cost’?  

Brokerages and Impact cost!

Yes. Just like us, funds have to pay brokerage when buying and selling a stock. Brokerages are not reported separately but the NAV is calculated after deducting the brokerage fees. SEBI has a cap on brokerage charges of 0.12% on every transaction for mutual funds. So if a fund buys and sells, it has to pay these charges that get deducted from our corpus. Obviously, we can’t avoid these fees but can the fund reduce it? But how to determine how much brokerage a fund may has paid? The shortcut to check this is by looking at Turnover Ratio of a fund which is available in the factsheet. This factsheet is published monthly. Alternatively, you can also check this on MoneyWorks4me.com website.

This ratio is reported as a %age of its portfolio. A fund has a turnover of 100% means it rotates the whole portfolio in 1 year. Other way to look at it is, even if few stocks may stay the same, remaining portfolio might be shuffled two-three times over. Similarly, if it is turnover of 20%, it means a fund changed 20% of the portfolio in one year that is, it typically holds a stock for 5 years.

If stocks are held for one year bought & sold, brokerage cost for a fund with 100% Turnover Ratio would be 0.12%X2 =0.24% on overall fund. This 0.24% went out from our investment.

For 20% turnover fund, it would be 20% of 0.24% i.e. 0.058%. So you see this is drastically lower than 100% Turnover fund. Please remember whatever we save compounds and hence has a significant impact especially when delivering benchmark returns is not easy and getting more difficult going forward. Hence Lower Turnover Ratio fund must be preferred.

Coming to another big hidden cost – Impact Cost.

What is an Impact Cost?

Since funds have to buy or sell large block of stocks, they do not get a seller or a buyer at their desired price. They have to settle with slightly higher cost for acquiring large block and a lower than reported price when selling a large block. This leads to reduction in returns earned.

This can amount to as large as 1% of portfolio in 100% Turnover Ratio fund. Impact costs is another hidden cost that eats into our corpus. For a lower Turnover Ratio fund, this cost would be lower too.

Research has shown that low churn reduces cost and adds more value in the long term than picking stocks for short term positive movements. Given that fund managers are very intelligent professionals, they must be taking these decisions despite knowing this. The only reason then is that they are driven to shown short term performance even at the cost of what is good for long term investors. As investors in mutual funds where we are rightly told repeatedly to stay invested for the long term, isn’t it wise to prefer funds managers who rotate their portfolio less and still deliver?

We recommend only buy mutual funds that have lower Turnover Ratio. Though in past many Indian Mutual Funds have beaten the market, the future won’t be as good due to increase in competition and that outperformance reduces as market gets developed.

The reason that Index Fund, a statistically constructed portfolio, is hard to beat is that it has low brokerage cost and low impact cost. Turnover Ratio of an index fund is much lower and this gives it an edge. Buying good funds with a low Turnover and Expense Ratio assures us that we are with a fund manager who is more likely to beat the index and hence justify our investment in them.

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