In the past few years, mutual funds have become extremely popular among Indian investors. They offer individuals a way to diversify their portfolios and participate in the stock market without requiring significant expertise. However, one thing many investors overlook is the presence of hidden fees that can quietly eat into their returns.
In this blog, we are taking a deep dive into the different hidden fees associated with mutual funds, how they affect your returns, and what you can do to avoid them.
Expense Ratio: The Ongoing Cost
The expense ratio represents the annual operating costs of managing a mutual fund and is expressed as a percentage of the fund’s average assets under management (AUM). The expense ratio includes fund management fees, administrative costs, and distribution expenses.
Why Is It Important?
While the expense ratio is disclosed upfront, its long-term impact is often underestimated by investors. A small percentage difference (e.g. 1.5% vs. 2%) might seem negligible in the short term, but over time, it can have a massive effect on your overall returns because of the power of compounding.
What To Watch Out For?
- Compare Funds – Within the same category (e.g., equity funds or debt funds), compare expense ratios. Actively managed funds often have higher expense ratios than passive funds like index funds.
Exit Load: A Fee For Leaving Early
An exit load is a penalty charged when you redeem your mutual fund units before a specified holding period, typically ranging from 1 to 3 years for equity funds. The idea is to discourage short-term trading.
Why Is It Important?
Exit loads don’t show up until you decide to sell your fund units, which makes them easy to overlook during the initial investment decision. For most mutual funds, exit load is charged only for a specified duration after which there is no exit load.
Also read: Different Types Of Mutual Fund Schemes
What To Watch Out For?
- Check The Lock-In Period – Before investing, check if the fund charges an exit load and how long you need to hold your investments to avoid it.
- Consider Your Investment Horizon – If you think you might need liquidity in the short term, choose a fund with no or minimal exit load.
Transaction Costs: The Invisible Drag
Transaction charges are mutual fund fees that are levied when you purchase and sell units whose value exceeds a certain limit.
For first-time investors, a fund house is allowed to pay ₹150 as a transaction charge where the transaction or SIP (Systematic Investment Plan) commitment value is ₹10,000 and above. On the other hand, the transaction charge will be ₹100 for existing investors.
In the case of SIPs, a transaction charge of ₹100 is payable in 4 equal instalments, starting from the 2nd to the 5th instalment, provided the total commitment towards SIP is ₹10,000 or above.
Why Is It Important?
Transaction charges aren’t explicitly disclosed to investors, which makes them difficult to track.
What To Watch Out For?
- Turnover Ratio – Funds with high turnover ratios tend to have higher transaction costs. Go for funds with lower turnover to minimise these hidden expenses. (Turnover ratio provides a measurement of how many times the fund managers bought or sold the assets under a fund over a period of time).
- Consider Index Funds – Passive funds, like index funds, generally have lower turnover and therefore incur lower transaction costs compared to actively managed funds.
Stamp Duty: A New Addition
Stamp duty has been applicable to the purchase of mutual funds since July 2020. A stamp duty of 0.005% is levied on the value of units purchased. For the transfer of mutual fund units between Demat accounts, a stamp duty of 0.015% will be applied.
Stamp duty is applicable on lump sum investments into equity and debt fund schemes, SIPs into any mutual fund scheme, Systematic Transfer Plan (STP) for any mutual fund scheme, and dividend reinvestment transactions.
Also Read: Top Strategies To Reduce Mutual Fund Risk
Why Is It Important?
The fee may add up, especially if you are investing large sums of money or making frequent transactions.
What To Watch Out For?
- Impact On Shorter-Term Investments – While this fee might seem negligible, it can be relatively higher for shorter-term holdings. However, the impact will be minimal for long-term holdings.
- Factor It Into Your Costs – Although small, consider the stamp duty while calculating your potential returns, especially for high-frequency investors.
Securities Transaction Tax (STT): The Direct Tax
STT is a direct tax levied on every purchase and sale of securities that are listed on the recognised stock exchanges in India. An STT of 0.001% is levied by the government when you decide to buy or sell mutual fund units of an equity fund or a hybrid equity-oriented fund. There is no STT on the sale of debt fund units.
Why Is It Important?
Investors often overlook this tax because it’s embedded within the trading activities of the fund. The cost is not itemised in the fund’s breakdown of expenses, making it hard to see its direct impact.
What To Watch Out For?
- Impact On Equity Funds – STT only applies to equity-oriented funds, so it’s less of a concern for debt funds.
- Long-Term Strategy – If you’re planning to invest in equity mutual funds, holding for the long term can help minimise the impact of STT over time.
Switch Price: The Cost For Moving Funds
The Switch Price is the cost incurred when you move (or “switch”) your investments from one mutual fund scheme to another within the same mutual fund house. This action can be attractive for investors looking to rebalance their portfolios or shift from equity to debt funds based on market conditions.
Why Is It Important?
These fees are often not highlighted and may surprise investors who are unaware of the implications of switching funds.
What To Watch Out For?
- Increases Costs – Frequent switching, especially between funds with higher exit loads or switching fees, can significantly reduce your returns.
- Mitigation – Be mindful of switching only when necessary, such as during strategic portfolio rebalancing, and opt for funds with no or low switching fees.
Taxes On Capital Gains: The Silent Hit
While not a direct fee charged by the mutual fund, capital gains tax is a cost that investors need to be mindful of.
- Short-Term Capital Gains (STCG) from Equity Funds – These gains are taxed at a flat rate of 15% irrespective of your income tax bracket.
- Long-Term Capital Gains (LTCG) from Equity Funds – These gains of up to ₹1 lakh a year are tax-exempt. Any long-term capital gains exceeding this limit attract a tax at 10%, without indexation benefit.
- Gains from debt mutual funds will be added to your taxable income and taxed at the slab rate.
Why Is It Important?
Capital gains taxes are often an afterthought for investors, but they can significantly reduce your real returns, especially if your mutual fund is actively managed and frequently realises gains.
What To Watch Out For?
- Tax-Efficient Funds – Consider tax-saving mutual funds (ELSS) of funds with lower turnover to reduce taxable events.
- Hold For The Long Term – By holding your investments for the long term, you can minimise short-term capital gains taxes and benefit from more favourable LTCG rates.
Hidden Fees In Mutual Funds – The Conclusion
Investing in mutual funds can be a great way to grow your wealth, but hidden fees can erode your returns if you’re not careful. From expense ratios and exit loads to transaction costs and taxes, understanding these hidden fees is crucial to maximising your investment returns.
To reduce the impact of these fees, always read the mutual fund’s Key Information Memorandum (KIM) and Scheme Information Document (SID). Always make sure to compare funds within the same category and opt for low-cost options like index funds or funds with lower turnover. By being vigilant and proactive, you can ensure that more of your hard-earned money stays in your portfolio, helping you achieve your financial goals faster. Create an account with Koshex to learn every detail of mutual fund schemes and make informed investment decisions.
Frequently Asked Questions (FAQs)
What is a turnover ratio, and how does it relate to hidden fees?
The turnover ratio represents how frequently a fund buys and sells securities. A higher turnover ratio usually results in higher transaction costs, which are indirectly paid by the investor. Lower turnover ratios typically indicate lower hidden fees.
Do mutual funds charge fees when I buy or sell units?
Yes. Some mutual funds charge a transaction fee when you buy units and an exit load when you sell units before the completion of a specified holding period. Additionally, stamp duty is charged at 0.005% on the purchase of mutual fund units in India.
Also Read: Can Mutual Fund Shares be Sold at Any Time?
How can I avoid or reduce hidden fees in mutual funds?
You can reduce hidden fees by:
- Holding investments for the long term to avoid exit loads.
- Choosing passive funds or index funds, which have lower transaction costs.
- Reviewing the Key Information Memorandum (KIM) or Scheme Information Document (SID) for a breakdown of all applicable fees.
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