Sunday, October 08, 2006

Further Concepts Clarified… !!!!

Further Concepts Clarified…

NAV is the most important measure of the performance of a Mutual Fund. Let us say you have invested Rs 10000 in a scheme at Rs 13 a unit and now its NAV is Rs 15. Quite simply, that means your investment has appreciated by 15%. But wait before you jump in joy - you may not actually get that much when you redeem your units. That is because of the expenses charged by Mutual Funds.

Let me introduce you to some concepts associated with Mutual Fund expenses before we proceed with the example. Mutual Fund’s costs are categorized as Sales charges or Loads and Operating expenses or Expense Ratio.

Loads include expenses like agent’s commission, marketing and selling expenses that are charged directly to the investor. Front End load or Entry load is a fee that is charged up-front, when you purchase the mutual fund units. It is charged on a percentage basis (eg. 1%, 1.5%, 2%, 3%, etc) based on the amount of purchase. Back End or Rear End load or Exit load is a fee that is charged at redemption.

Expense Ratio is an annual operating expense expressed as a percentage of the fund's average daily net assets. It refers to costs incurred in operating a mutual fund and is paid out of the Fund’s earnings. It includes advisory fees paid to investment managers, audit fees, custodial fees, transfer agent fees, trustee fees etc. Operating expenses are calculated on an annualized basis and are normally accrued on a daily basis. Therefore, you pay expenses pro-rated for the time you are invested in the Fund.

Let us return to our example. If the entry load levied is 1.00%, the price at which you invest is Rs.13.13 per unit. This is the Purchase Price, the price paid by a customer to purchase a unit of the Fund. You receive 10000/13.13 = 761.6146 units.

Let us now assume that you decide to redeem your 761.6146 units and the exit load is 0.50%. The Redemption Price per unit works out to Rs.14.925. Redemption price is the price received by the customer on selling units of an open-ended scheme to the Fund. You, therefore, receive 761.6146 x 14.925 = Rs.11367.10. The returns have reduced to 13.6% as a result of entry and exit loads.

Repurchase Price is different from Redemption Price and refers to the price at which a close-ended scheme repurchases its units. Repurchase can either be at NAV or can have an exit load. (Open-ended and Close-ended Funds will be discussed under classification of Mutual Funds).

Suppose the Expense Ratio is 2%, you will see a return of only11.6%. So your returns have come down by 3.4 % as a result of the Loads and Expense Ratio.

Now, you can appreciate the extent to which Mutual Fund Expenses eat into your real returns. This should not scare you away from Mutual Funds since the associated cost for Mutual Funds is still very low when compared to making investments directly in equities. This notwithstanding, a proper understanding of Mutual Fund expenses will stand you in good stead when you have to choose from among equally well-performing Funds.

Mutual Fund expenses will be explained and analysed threadbare in the subsequent blogs.

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