Do you need to pay a commission while buying a mutual fund product and are there any hidden charges/ fees? How are financial advisors compensated?
You do not need to pay a commission directly, while buying mutual funds via an agent or a distributor. However, as with all other investment products, mutual funds too have costs involved- which may affect the value of your investment in one way or the other. These could pertain to the professional money management services, distribution and sales, brokerage, etc. Before you invest, you need to know the costs that your investment is likely to incur, as it has an impact on the returns that you realize from that investment.
What are the costs involved in mutual fund investing?
You know that mutual funds are professionally managed collective investment schemes. Hence, they incur a few expenses in running the fund on behalf of investors. These expenses are ultimately borne by the fund’s investors. Some of the major expenses are:
Commissions: Mutual funds engage the services of agents and distributors who sell the mutual fund products to investors. These intermediaries are compensated by the mutual fund houses through commissions.
Fund management fees: The fund house hires professional managers to manage the investments of the fund. They are compensated for their service through a fund management fee. This is usually a specified percentage of the fund assets.
Brokerage and taxes: Fund managers buy and sell securities for the scheme; this results in transaction costs being incurred (brokerage, Securities Transaction Tax (STT), stamp duty, service tax etc.)
Administrative expenses: The fund house has an administrative set up which runs the operative functions of the fund house. These could be marketing, accounts, legal compliance, finance, custodianship, registrar and transfer agents, etc. These administrative costs are charged to investors. While these services will be common across many schemes that a fund house runs, they are apportioned to individual schemes proportionately.
Expense ratio of mutual funds
The market regulator Securities and Exchange Board of India (SEBI) specifies the maximum limit for the expenses that schemes may charge to investors. This is called the Total Expense Ratio (TER) which is usually a specified percentage of the assets managed by the scheme. TER would include all expenses and is calibrated on slabs of asset size (up to Rs 100 crore, up to Rs 300 crore, etc.). The TER varies with the nature of assets and the nature of fund management. For example, equity funds have the highest TER while liquid funds would generally have a low TER. Similarly, actively managed schemes would have a high TER while passive schemes (index funds, ETF, etc.) have a low TER as they transact less and have a slightly lesser role for the fund manager. Fixed maturity Plans (FMPs) would also have a low TER as the investment decision and action of the fund house is a one-time affair. Any scheme has to manage its expenses within this allowed TER. The actual expense (as a percentage of its total assets) is the expense ratio of that scheme which is disclosed in its periodical fact sheets. The TER effectively reduces the returns of the scheme.
Direct Plans versus Regular (Distributor) Plans
While many of the components of the TER are common across all categories of investors, the distribution and sales related expenses are levied only for those investors that utilize the services of intermediaries like agents and distributors. As an investor, you have the option of bypassing the intermediary and investing directly with the fund house in their ‘Direct Plans’. In this case, you can save the distribution related expenses. In other words, Direct Plans would have a lower expense ratio than the Regular Plans. But you need to have adequate knowledge, temperament and time to make investment decisions that suit your needs. If you need to utilize the service of the distributor, you would then have to invest in ‘Regular Plans’ and would be levied the distribution related expenses. This effect is visible in the NAVs of Direct Plans vs Regular Plans of a mutual fund product. Generally speaking, direct plan NAVs are higher than regular plan NAVs.
How are financial advisors compensated?
Your Relationship Manager at the Bank or from the Financial Distribution Company, just like an Independent Financial Advisor, earn their income primarily in the form of commissions from the products (mutual funds, insurance, etc.) they sell to you. Some IFAs may also charge a direct advice-oriented fee to their clients.
Certified Financial Planners and Registered Financial Advisors only charge their customers for their expert advice and do not earn commissions from product manufacturers.
Conclusion: Mutual fund investing has its own set of costs though they are relatively less expensive than many other collective investment schemes. If you utilize the service of a distributor or agent, you would incur a higher cost than going direct to the fund house.
Disclaimer: The information present above is as per current SEBI Regulations governing distributors, which may change from time to time. We recommend that investors speak to their advisors and understand their compensation model, before investing.
1.As with any other investment, mutual fund investing too involves certain costs.
2.These costs relate to the fund management service, sales expenses and other administrative expenses.
3.SEBI specifies the TER for each fund category depending on the nature of assets and fund management.
4.The actual expense ratio is disclosed by each scheme in its periodical factsheet.
5.Direct Plans have a lower expense ratio than Regular Plans.