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MFs charge investment & advisory fees. This is taken out from NAV & accrues on a daily basis

MF Compensation
I have been wondering what mutual funds get out of managing my money? If they get anything and I assume they would, is this based on performance and does this change from fund to fund?
- Arvind C. Jain

There are no free lunches in life and this applies to mutual funds also. Mutual funds charge a fee called investment and advisory fees for managing your money. This is deducted from the NAV and accrues on a daily basis. The upper limit of this fee is capped by regulations and is independent of the performance of the fund. Thus in an equity scheme, the fund can charge up to 1.25 per cent for the first Rs 100 crore of assets. If the fund manages any sum above Rs 100 crore then it can charge up to 1 per cent for the excess amount. For debt schemes, the fee is lower by 0.25 per cent for each slab. So effectively for an equity fund, which is not more than Rs 100 crore in size, the maximum management fee that an asset management company can charge is 1.25 per cent and for a similar sized debt fund it is 1 per cent.

But if a fund is launched on a no-load basis and does not levy any initial issue expenses, then the asset management company can charge up to 1 per cent more, as management fee for each financial year. For this reason some funds may charge slightly more than the limits we have mentioned.

While the upper limit is effectively capped depending on whether a fund is an equity fund or a debt fund, an AMC can charge a lower management fee if it wants to. Two categories of funds where this happens are index funds and the institutional plans of debt funds. In an index fund the AMC does not have to take an active call on which stocks to buy and sell. The fund just has to replicate an index, so research and other management inputs are minimal. Consequently the management fee charged here is much less. Similarly, institutional debt funds have been launched with the purpose of passing on the lower cost of mobilizing funds to their unit holders. One way of doing this is to charge a lower management fee. Thus the fund houses charge a lesser management fee for the institutional plans of their debt funds.

The management fee that you pay a fund company to take care of your money is a component of the expense fee. Expense fee (also called expense ratio) tells you what part of your returns is being consumed to administer and manage your money. If your fund has given you a return of 10 per cent and its expense ratio is 1.2 per cent then your fund had actually generated 11.2 per cent. So, this fee is more relevant to you than just the management fee. While the management fee just tells you what portion of your investment is being consumed by the AMC, the expense ratio tells you the total value of your investments, which is being consumed in running the fund, and this includes other costs such as advertising and marketing. The expense ratio of an equity fund cannot exceed 2.5 per cent of the assets under management, while for debt funds the limit is 2.25 per cent.

Timing Investment
Since the Sensex is riding high, is it not better to wait for equity fund NAVs to fall before investing?
- K. Swamy

Yes, it's always better to invest at lower levels and exit at higher levels. That's the dream plan for every investor. But, is it possible to time such investments? You really never know what's the best time to purchase units of a particular mutual fund. It would be a guessing game. Markets may rise one day and fall the next day. Accordingly, the fund's NAVs will rise and fall. Moreover, how should one go about deciding what is low and what is high?

The Sensex is currently hovering over 12,700-mark, which according to you is very high. But if it rises another 1,000 points to touch 13,700 in a few months, won't your calculations go wrong? Of course, your calculation may work in your favour if the Sensex slips 1,000 points. Frankly speaking, timing the market is nearly impossible.

Thus, instead of waiting for equity fund NAVs to fall, invest regularly and systematically in mutual funds irrespective of booms and busts. It is the surest way to reduce the risk of investing, because you lessen the possibility of buying at market tops. Also, no one is smart enough to anticipate all the moves, both up and down. Invest in funds with the idea of holding on to them for a long period.

Clearly, time can be a better friend than timing. If you are not a professional money manager, your best bet is probably to buy and hold. Through this strategy, you can take advantage of the power of compounding on your returns.

ETFs Demystified
What is an exchange traded fund (ETF)? How is it different from a normal equity fund?
-Dipika Sharma

Exchange Traded Funds (ETFs) were first launched in India in December 2001 by Benchmark AMC. ETFs are fundamentally different from normal funds and have thus developed something of a reputation for complexity. While some of the details of how AMCs run ETFs are genuinely complex, that has nothing to do with the investors. For the investors, ETFs are a straightforward instrument offering some interesting features. Let's see what makes ETFs different.

ETFs are index funds. An index fund is an equity fund, which tracks a particular index like Sensex or Nifty. The index fund holds the same stocks as the underlying index and in the same proportion as the index. From an investment point of view, ETFs are simply index funds that-unlike normal index funds-can be bought and sold at intra-day prices. In this respect they are more like shares rather than MFs. Normal index funds are, of course, available only at end-of-day NAVs from fund distributors. ETFs, since they need to be transacted upon throughout the day, are bought and sold through stockbrokers (using a demat account) just like shares.

However, behind the scenes, ETFs are very different from any other kind of fund. Where an ETF really differs from an index fund is the manner in which it is created, bought and sold. In the case of normal mutual funds investors pay cash to the fund, which in turn buys the stocks and bonds. When ETFs are set up, the initial participants will give the fund the basket of stocks, which constitute the underlying index and take units of the fund in exchange. These market makers will in turn sell these units to investors just like a distributor does. The market maker is usually a broker. Since ETFs are sold through brokers, you will pay brokerage in place of loads. ETFs tend to have lower brokerage than normal funds' loads.

The NAV of an ETF is a fraction of the value of the index. Thus the NAV of an exchange-traded fund based on the Nifty can be one-tenth of the value of the Nifty. If the Nifty is at 3500 points the NAV will be Rs 350. Effectively, this fractional pricing means that a basket of stocks on Nifty can be purchased by an investor with a much lower outlay than it would otherwise be possible. This also enables smaller initial investments than what most index funds offer, which is especially useful if you are just trying out index investing. By comparison, most Nifty index funds require a minimum investment of Rs 5,000.

In the case of other MF schemes, a fund buys back and sells units. In a way, an ETF resembles a close-ended scheme, where the units are not sold back to the fund and investors buy and sell the fund units on the market. However, there is obviously no discount to NAV like closed-end funds. Unlike a close-end fund, supply can be altered by creating additional units or extinguished by withdrawing existing ones. Trading of the units ensures that underlying stocks do not have to be bought or sold. Investors entering and exiting do not also affect existing investors. An ETF has a much lower tracking error than an index fund.

Star Funds
Is it a good idea to invest only in Five or Four Star rated funds for a time period of 3 years in debt and 5 years in diversified equity funds?
- Vitthal Prabhu

Selecting a good fund to invest in is definitely an important first step. And there is no better place to start than the Value Research Fund Rating on valueresearch-online.com. In one go you can get a snapshot on the best performing funds in terms of their historical risk-adjusted returns. Funds, which are rated as Four and Five Stars, have some of the best risk-adjusted returns in their category.

However, ratings are only the starting point. After selecting the funds you want to invest in, you should look for their investment objectives and aims. You should be comfortable with the way a fund generates its returns. Two funds may be rated as Five Star, but one may generate returns through a concentrated portfolio, while the other may be more diversified. Some funds may move heavily into cash while others may remain fully invested. Similarly, some schemes may invest heavily in mid-caps, while others will stick to large-caps. So, it is not just important that a fund generates high risk-adjusted returns but how it does it. As ratings are a purely quantitative exercise, they cannot capture these facets of a fund's performance. Ratings can help, but they cannot take you all the way to your destination.

Once you have selected your funds, do work out an asset allocation, i.e., the amount you will invest in equity and debt. This will depend on the risk you can take and the duration for which you can remain invested. As a general rule, for a period greater than five years, equities are suitable, while for smaller time periods, you should opt for debt instruments. Along the way, do rebalance your portfolio at regular intervals so that your ideal allocation is maintained.

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