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What are the risks, costs & returns in Mutual Funds?

by Lalitha

Risks

Mutual Funds invest in securities such as stocks and bonds which are actively traded in the stock exchanges. Hence the risks involved in investing in the underlying stocks and bonds are applicable to the Mutual funds holding these securities.

  • Equity funds would carry the highest risk since they are subject to volatility in the stock markets due to micro or macro-economic factors.
  • Debt funds invest in government and corporate bonds, so they carry moderate to low risks. These funds are subject to macro-economic performance of the country (fiscal and trade deficit), interest rate situation, inflation, forex currency fluctuation and so on.
  • Liquid funds carry the least risk since their tenure is low and most of them invest in sovereign gilt (government papers) which carries very low risk of default (for India at the moment).

Costs

The fund house charges you a fee as a fund manager actively manages your funds. There are annual expenses, management fees, distributor fees (upfront commission, trail commission etc), which are all lumped together and published as “Expense Ratio” of the fund. The expense ratio could range from 0.5% to 2.75% depending on the fund category. Generally ETF funds, gilt and passive funds charge a low fee while equity funds charge high fees. You do not need to pay the various fees explicitly but it all gets deducted from your units’ NAV value at the end of each day. Be aware that a very high expense ratio + average performance could erode your wealth, so when choosing a fund, you need to consider a fund’s expense ratio in addition to its performance.

Returns

Returns are commensurate with risks and investment horizon of the funds. For example, it is not prudent to invest Rs.5Lacs in equity funds if you need the money within 2-3 years. Similarly if you’re looking at wealth creation, it does not make sense to invest in gilt funds – for this goal, equity funds with 7-10years horizon is more suited as it could provide a CAGR (Compounded Annual Growth Rate) of 15-20%, which could not only beat inflation but also multiply your investment by 4x-6x.

Buy thru a distributor or online platform or direct from the fund house?

If you are investing through your bank or any of the popular brokers, they act in the capacity of a distributor. This means they get to earn commission by selling funds to you. There could be a window of opportunity for conflict of interest or mis-selling, so you need to be careful when buying funds via distributors. These days several online portals & mobile apps provide free accounts where by you are not charged anything for buying and holding funds via their portal (but you still pay higher expense ratio compared to direct plans). If your choice of say 8 funds is limited to a max of 5 different fund houses or AMCs (Asset Management Companies), check with your financial planner to see how much you could save (in thousands) if you switch to direct plans!