BS Primer: Ever wondered how Mutual Fund houses make money?

What are Mutual Funds?

Mutual funds are investment schemes which offer a bundle of securities to the investors while spreading the risk of investment at the same time. Investors have the advantage of picking one scheme of their choice and thereby avoid the Herculean task of analysing hundreds of stocks themselves before making a choice. At a nominal fee, mutual funds provide a great opportunity to investors who don’t have the knowledge of investing. They can pick one financial goal and choose a mutual fund scheme which suits their goal. Afterwards, they can simply invest in that preferred scheme to accumulate wealth without any hassles. Mutual fund schemes are offered in two variants i.e. as direct plans and regular plans. Investors who want to avail the services of an intermediary like a mutual fund distributor, may choose the regular plan.  

How do Mutual Funds work?

Mutual funds is an arrangement in which your money is pooled with that of other investors and invested in a portfolio. Such a portfolio is composed of various asset classes like equity stocks, bonds and cash. The proportion of investors’ money going into each asset class is determined by the investment objective of the fund. In a way, you are able to take exposure to those stocks which would have been difficult single-handedly. Likewise, some mutual funds invest in overseas markets and stocks listed in other countries. Such an opportunity is very difficult to explore for an inexperienced investor on his own.

The entire fund portfolio is managed by an experienced person known as the fund manager. Each fund house appoints a fund manager to take investment decisions with respect to a mutual fund scheme. He takes calls about stock-picking, monitoring the portfolio, and keeping track of industry developments. Such type of fund management is known as active investing wherein the fund manager adjusts the portfolio according to changes in the overall economy. He/she aims at maximising the overall returns while keeping the risk profile of portfolio intact.

How do Mutual Funds make money?

For a mutual fund enthusiast, it is important to know about how the mutual funds make money. Actually, each fund house charges the investor an annual fee which is expressed as percentage of the asset under management. It is called as the expense ratio. It indicates the cost of managing one unit of the fund. Overall, a fund house makes money by charging one-time expense and recurring expense.

1. One-time expenses
 

The one-time expenses consist of charges which the fund house levies in the form of loads. Usually, these incur at the time of entering or redeeming a scheme. Prior to 2009, the fund house used to charge entry load from the investor upon purchase of units of a mutual fund scheme. Such a load would lower the actual amount going in for investment in the chosen scheme. Thus, after 2009, SEBI banned the practice of levying entry loads on mutual funds. Exit load, expressed as a percent of current fund Net Asset Value (NAV), is yet another kind of one-time expenditure. It is charged when an investor sells units of a mutual fund scheme. It differs from one scheme to another and is levied upon a redemption within the lock-in period. But, once the lock-in period gets over, there are no exit loads.

2. Recurring Expenses

The Total Expense Ratio (TER) covers all kinds of management fee and other fund administration charges that are needed by a fund house to perform day-to-day operations. Recently, SEBI redefined the entire cost structure of mutual funds thereby reducing the overall TER. For open-ended equity schemes, the new TER ranges from 1.75% to 2.25% of the daily average asset under management. Ideally, the fund house should be able to reduce its overall expenditure as it grows in size. Additionally, the fund houses have to move from upfront commission system to an all-trail model for compensating the distributors. In the all-trail model, a redemption or a fall in investor’s fund value may also affect the commission received by the distributor.

(Author is the founder & CEO of ClearTax)