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An informed investor knows where his money is
going. For an investor in mutual funds, it is essential to
understand the expenses of mutual funds. These expenses directly
influence the returns and cannot be neglected.
The
expenses of mutual funds are met from the capital invested in them.
The ratio of the expenses associated with the operation of the
mutual fund to the total assets of the fund is known as the expense
ratio It can vary from as low as 0.25% to 1.5%. In some actively
managed funds it may be even 2%. The expense ratio is dependant on
one more ratio ??the turnover ratio?
?The turnover rate or
the turnover ratio of a fund is the percentage of the funds
portfolio that changes annually. A fund that buys and sells stocks
more frequently obviously has higher expenses and thus a higher
expense ratio.
The mutual fund expenses have three
components:
The Investment Advisory Fee or The
Management Fee: This is the money that goes to pay the salaries
of the fund managers and other employees of the mutual funds.
Administrative Costs: Administrative costs are the costs
associated with the daily activities of the fund. These include
stationery costs, costs of maintaining customer help lines and so
on.
12b-1 Distribution Fee: The 12b-1 fee is the
cost associated with the advertising, marketing and distribution of
the mutual fund. This fee is just an additional cost which brings no
actual benefit to the investor. It is advisable that an investor
avoids funds with high 12b-1 fees.
The law in US puts a
limit of 1% of assets as the limit for 12b-1 fees. Also not more
than 0.25% of the assets can be paid to brokers as 12b-1 fees.
It is important for the investor to watch the expense ratio of the
funds that he has invested in. The expense ratio indicates the
amount of money that the fund withdraws from the funds assets every
year to meet its expenses. More the expenses of the fund, lower will
be the returns to the investor.
However it is also
essential to keep the performance of the funds in mind too. A fund
may have higher expense ratio, but a better performance can more
than compensate higher expenses. For example, a fund having expense
ratio 2% and giving 15% returns is better than a fund having 0.5%
expense ratio and giving 5% return.
Investors should note:
It is not sensible to compare returns of funds in different risk
classes. Returns of different classes of funds are dependant on the
risks that the fund takes to achieve those returns. An equity fund
always carries a greater risk than a debt fund. Similarly an index
fund that invests only in relatively stable and thus less risky
index stocks, cannot be compared with a fund that invests in small
companies whose stocks are volatile and carry greater risk.
Avoiding funds with high expense ratio is a good idea for the new
investor. The past performance of a fund may or may not be repeated,
but expenses usually do not vary much and will certainly reduce
returns in future too.
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