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Mutual Funds - Four things that can be a drain on your mutual fund returns

16 Dec 2019

As the stress in the economy continues, equity market investors must be prepared for lower returns. While nothing much can be done about that, protecting the returns assumes greater significance in such a scenario. So when evaluating schemes, it becomes important to look beyond the risk and return parameters and consider other elements of the portfolio that can impact their performance. Here are four such elements that can put a drain on the effective returns from your mutual fund investments.

Expense ratio

The expense ratio is the cost that is charged to meet the operating expenses of a fund such as fund management, administrative and legal costs and auditor and registrar and transfer agent fees. The net asset value (NAV) of a fund is declared after accounting for the expenses on an ongoing basis.

It is usually ignored because it is not a cost that is paid out of your pocket directly, but it can shave off a significant chunk from your returns, especially in case of long-term equity investments, where the compounding effect shows its impact. For example, a 1% difference in the expenses charged that translates into an equivalent difference in returns will mean a corpus that is lower by 6% over a 10-year period for the investor.

While the Securities and Exchange Board of India’s (Sebi) guidelines on expenses have become stricter and have linked them to the size of funds, even funds of comparable AUM (assets under management) charge a range of expenses. An actively managed fund justifies the expense ratio by its ability to out-perform the benchmark, in rising as well as falling markets, but evaluate a fund’s ability to do so consistently before signing up for higher expense ratios. “We prefer schemes that have lower expense ratios among peers," said Lovaii Navlakhi, founder and CEO, International Money Matters Pvt. Ltd.

Vidya Bala, head of research and co-founder, PrimeInvestor.in, believes investors should go a step further to evaluate the impact of expense ratios. “In categories like small-cap funds where funds are generally able to outperform the benchmark with a significant margin, the focus can be on the consistency of performance itself along with portfolio features and less on the expenses charged. But categories where fund managers struggle to beat the benchmark, say, large-cap funds, even a difference of 50 or 75 basis points in expense ratio will matter over the long term. The case for a higher expense ratio is lower after re-categorization since the element of active management is lesser," she added.

Portfolio Turnover

The portfolio turnover represents the churn in the portfolio of a mutual fund. It is measured by the portfolio turnover ratio and is the percentage of the portfolio that has changed over a 12-month period. Depending upon the strategy of the fund, its portfolio may feature a high or low turnover.

A low portfolio turnover ratio indicates a strategy of holding the stocks for a longer period and indicates lower transaction costs. A high ratio means greater trading in securities and higher costs. While a higher churn may or may not result in better returns, it definitely implies higher costs, including brokerage and securities transactions tax.

Consider the consistency with which a fund with a high turnover is able to generate higher returns for the additional risk and costs it takes. “Where fund managers have a tactical approach, the churn is likely to be higher. In a broad market rally such tactical moves can generate returns. But in a volatile market, this may hurt. A high churn can explain the underperformance of a fund in a volatile market," said Bala. “Too much turnover will hamper returns. While smaller variations in turnover may be ignored, a significantly higher turnover relative to comparable schemes will be a reason for a scheme to be eliminated from the consideration set," said Navlakhi.

Mint tracks the metric for various funds once a month .

Exit Load

Exit load is imposed to deter early exits from funds. Typically, funds charge an exit load of up to 1% on the redemption value for exits within a year, and this can impact the returns too.

As a rule, equity investments are not products for short-term investments, but if there’s a need and you have no option but to exit early, then consider the impact of exit loads. “Exit loads are typically aligned to the incidence of capital gains and we would consider it while planning an exit," said Navlakhi. “Since it can have a significant impact on returns, we advise investors to try and postpone redemption for the period when exit load will be levied," he added.

Tax

The post-tax return is what you finally get, so do consider the impact of various taxes.

Short-term gains (made within a year) from equity funds are taxed at 15% on realization; so consider equity funds for horizons above one year, when gains (considered long-term) above ₹1 lakh are taxed at 10%. Dividends from equity funds attract a dividend distribution tax of 10% that reduces the return. Unless regular income is important for you, avoid the dividend option. Instead, select the growth option, which allows the returns to remain invested. While there is a tax to pay in the long term too, the growth option gives better compounding benefits.

Minimizing costs is one way of maximizing returns. “Expenses are a certainty, while returns may not always materialize," said Navlakhi. This applies to all the costs and taxes.

The information that you want on expense ratio, portfolio turnover and exit load is easily available in the periodic disclosures that mutual funds mandatorily provide. A greater scrutiny of how a portfolio is managed at the time of making the selection will bring up these details and help you make an informed decision. Don’t use these measures in isolation, but it should be an important part of the evaluation process. Bala cautions about seeing these elements in isolation. “You should not penalize the fund based on one parameter but look beyond to understand what the fund/category is doing," she said.