In a country where subsidies are rampant (as is their misuse), most retail investors are not comfortable with paying a fee for investment advice. Ask any fee-only financial planner and he/she will tell you how prospective investors balk at being asked to pay a fee for advice. Their premise being advice should come for free.
Advice is by nature not validated until results are in front of us. This argument is applicable for investments too. Mutual funds, insurance, pension, alternative products — the list of available financial products for investors is growing. People know how much the net asset value of their mutual fund scheme moved. They also track how much return (or loss) the unit-linked plan (Ulip) gave last year. Ask them about the sum assured of their term insurance, pat comes the reply. But if you ask them what do they pay (as investment fee) to get that return, most don’t won’t an immediate answer.
Fee is important
A charge that eats up 1 per cent of your investment assets every year sounds low. But remember, the fee is levied every year irrespective of your money working for you or not.
Let the numbers to do the talking for a better understanding. Assume you have invested a lump sum of Rs 2 lakh each in two products. The first one charges 2.5 per cent fee annually (product A). The second one charges a modest 1 per cent per year (product B). You get identical investment returns of 8 per cent over five years from both products. What’s the net result?
Product B: Your Rs 2 lakh should grow at 8 per cent annual return to Rs 2.93 lakh. However, you paid Rs 12,401 as fees for five years at the rate of 1 per cent every year. So, your corpus after five years (before tax) is Rs 2.80 lakh. This means your actual rate of return is not 8 per cent but 6.96 per cent. Wait, that’s not as bad as you think.
Product A: You chose the product that charges 2.5 per cent fee annually. At 8 per cent rate of return, your initial corpus should ideally grow to Rs 2.93 lakh. However, you paid about Rs 30,000 as fee for five years at 2.5 per cent annually. This means your corpus after five years (pre-tax) is Rs 2.63 lakh. This translates to your actual rate of return being 5.63 per cent.
“Fees can impact your final returns in a major way. So, find out about them as much as you can,” says Anil Rego, CEO, Right Horizons.
Paying too much?
The all-important thing for you as an investor is knowing whether you’re paying too much. Use this brief guide to understand the typical costs of various investment products. If you realise that you have been paying more, you can save instant money by looking at cheaper options.
Mutual funds: For operating mutual funds, fees and expenses are recovered from investors. These expenses include investment management and advisory fee charged by the asset management company (AMC), registrar and transfer agents’ fee, marketing and selling costs etc. The maximum total expense ratio (TER) permissible under existing regulations for a mutual fund is 2.50 per cent. The lower the expense ratio, the better it is. Lesson: You can look at the monthly fact sheet provided by all mutual fund companies in their respective websites to understand their TER.
Distribution expenses are not charged in ‘direct’ plans and no commission is paid from ‘direct’ plans. The total expense ratio of a typical direct plan is lower by at least 5 per cent visa-vis the regular plan. That means if the expenses of a regular plan is 100 bps, the expenses of direct plan will not exceed 95 bps. Lesson: It pays to go ‘direct’ in MF investing as you save on costs.
Prior to the implementation of Sebi guidelines, an entry load of typically 2.25 per cent was charged on all equity-based mutual fund purchases. As per the new guidelines issued by Sebi that came into effect from August 1, 2009, there is no entry load. However, exit loads do exist. Some funds charge an exit load of 1 per cent for redemption within 12 months from the date of allotment. This exit load varies as does the time when redemption (three months or six months) occurs after date of allotment of units.
Exchange traded funds or schemes: Compared with equity mutual funds, exchange traded funds (ETFs) or exchange traded schemes (ETSs) have a maximum total expense ratio of 1.50 per cent. In terms of just costs, these products are more efficient. There is no entry load. Exit load is nil for units sold through the secondary market on the stock exchanges where the scheme is listed. Investors, however, must note that the brokerage on sales of units of the scheme on the stock exchanges has to be borne by investors. Investors can redeem units directly with the fund and there is no exit load for such transactions.
For index funds, another example of passive investing, the TER is comparable to ETFs/ETSs. However, they are likely to have exit load. Returns in mutual funds are market-linked but costs are mostly fixed. “The good thing is as an investor you know the costs upfront. The debate between active and passive investment products is never ending,” said Koel Ghosh, director - business development, Asia Index in a recent interaction.
National Pension System: We all know this product better by its abbreviation NPS. It has been recently announced that the NPS Trust will start recovering a fee/charge @ 0.01 per cent of the assets under management (AUM) on daily accrual basis to meet its expenditure, with effect from November 1. This has been approved by the Pension Fund Regulatory and Development Authority.
There are other charges as well. From the central record-keeping agency perspective, there is a permanent retirement account (PRA) opening charge of Rs 50, annual PRA maintenance cost per account is Rs 190 and charge per transaction is Rs 4. These are levied on NPS subscribers. In case of government employees, CRA charges are being paid by respective governments.
There are point of presence (PoP) charges also. An Initial subscriber registration and contribution upload of Rs 125 is charged. Any subsequent transaction is charged at 0.25 per cent of contribution (minimum Rs 20 and a maximum Rs 25,000). There is also an asset servicing charge. A good way to understand all this in a simpler manner is ‘charge ratio’ of NPS. This measures the impact that any type of administrative charge can have on the final balance (after 25 or 40 years) of an individual retirement account compared to the hypothetical balance that could be obtained if no administrative fees were charged at all. The charge ratio for private sector subscribers of NPS is 4.70 per cent while for government subscribers its 0.55 per cent, as per NPS Trust data. The figures are assuming that you have a monthly contribution of Rs 1000, your return on contribution is 8 per cent and your contribution period is 40 years.
NPS is one the cheapest pension products in terms of cost but its maturity proceeds are still taxable. In comparison, the proceeds from EPF are tax-free. However, EPF returns are fixed but NPS has greater flexibility in terms of delivering returns.
Insurance products: Cost of pure term insurance plans is not that important since the outcome of such a product is known before-hand. If you die during the policy being in force, the nominee will get the sum assured.
However, there are many different charges when it comes to a non-participating unit-linked plan. There is premium allocation charge. The actual premiums allocated to the fund of your choice is smaller by the extent of the premium allocation charge. The charges vary from product to product. For instance, one ULIP will have 6 per cent premium allocation charge in first year, then 5 per cent for second year, 4 per cent for third, fourth and fifth years. From year six onwards, there is usually no such charge for most ULIPs. For single premium policies, this charge is usually lower. Discounts are given if the policy is bought directly from the company website.
There is a policy administration charge too. In some products, this is charged monthly. This charge is usually a percentage of the annual premium or a fixed amount that is inflated monthly.
Next comes the fund management charge per annum, which is charged as a percentage of fund value. This is typically charged daily by adjustment to the net asset value. Equity funds are charged at 1.35 per cent while bond funds are charged the lowest. In products with investment guarantees, there is an additional charge.
Wait, there is more. Discontinuance charges are also applicable when the policy is discontinued during the policy year. Usually, this charge becomes nil after 5th policy year. Plus, there are mortality charges (cost of life insurance cover).
Alternative funds: These are hedge funds. It’s u nderstood that hedge funds charge 2 per cent of all assets and 20 per cent of any gains. In private equity investment products, the management fee is initially based on the total investor commitments. After 4–6 years, the basis for calculating this fee is changed to the cost basis of the fund. Management fees can be up to 2 per cent per annum at start and then may be halved. The fund managers here also receive an incentive fee based on the performance.
