Small expenses that erode your returns

Expenses incurred in making and holding investments may seem negligible, but in total they are significant

The interest that a deposit will fetch, or the expected appreciation in price of an equity share, or the returns expected from a mutual fund investment, are the first things that are considered while evaluating an investment. With all the discussions about risks, you may even consider the possibility of losing the money invested. However, most people do not consider the one certain aspect in the investment—the costs. Irrespective of the investment’s performance, the costs, fees and expenses linked to it have to be paid and that makes it a must-know before investing.

“When we construct a portfolio, we make choices among the products of banks, asset management companies, insurers and pension funds. In all the products, the stakeholders are the manufacturers, employees, distributors and consumers. Unfortunately, there are issues on the cost structure, expenses of management and fees charged to the customers," said Prakash Praharaj, founder, MaxSecure Financial Planners.

The impact of these expenses on returns can be significant. For example, a difference of just 1% in the annual expenses charged to two investments earning the same return translates into a difference of close to 16% in the final value over a 20-year investment period. This difference goes up to over 20% if the holding period was 25 years. It is important, therefore, to look at the costs involved in making, holding and exiting an investment while evaluating options, and not merely the risks and returns. Expenses drag down returns earned on an investment, particularly in the long run because they take away a chunk, which is then not available to the investor to grow and add to the final corpus value.

Understand the costs

Transaction costs are one-time fees imposed at the time of making or exiting an investment, or both. Broking fees are charged at the time of buying or selling a security on the stock exchange; exit loads at the time of redeeming mutual fund units; and commission fees are charged at the time of making a deposit. All these are examples of transaction costs. They are typically charged as a percentage of the amount invested or redeemed, and reduce the amount invested or the money received upon redemption. A 1% commission on a 1 lakh investment means only 99,000 gets invested, or a 1% exit load on an investment with a redemption value of 1 lakh means the investor receives only 99,000.

“Understanding costs will help reduce surprises in the future. It will help demystify the charges that will reduce the overall return or performance of a product, and what one will make or earn in hand. Investors are not averse to fees being charged, as long as the same is communicated upfront in a clear and transparent manner," said Dilshad Billimoria, director, Dilzer Consultants Pvt. Ltd.

Ongoing fees are charged throughout the term of the investment. Investors tend to overlook these because the amount seems too small to cause any real damage. Moreover, the expense is typically deducted from the investment value, and since there is no direct payment made for it by the investor, there is a greater tendency to ignore it. However, that would be a mistake.

Here is an example to explain the effect of ongoing charges. A 1% ongoing expense charge can deplete the final portfolio value by almost 18% over a 20-year period on an investment growing by 10% per annum. A 0.5% expense charge can reduce your portfolio value by almost 10%. Remember, the expense is calculated and charged on the current value of the portfolio. As your investment increases in value over time, so will the expenses. Every time the expense is charged, the investor loses a portion of her portfolio value and this is not available to compound and grow over time.

Different products have various costs attached to them. Insurance policies, for example, have mortality charges, administration charges, and fund management charges. In mutual funds, there are fund management fees and commission charges that form part of the expense ratio of a scheme.

There are hidden costs as well which are not explicitly designated as such in the product literature but can still be a drag on the investment value. For instance, premature withdrawal of a term deposit with a bank results in a lower penal interest.

Evaluate costs

The fees and costs may seem small, and even insignificant in some cases, compared to the return numbers that are being talked about and focussed on. But these can impact returns on an investment.

The best way to be able to deal with costs is to have complete information about them, from multiple sources if needed.

“Ask your financial adviser, ‘Am I missing something?’ When you buy a white good from the market, often it says it has 0% down payment and an equated monthly instalment (EMI) option. What you don’t realise is that you are probably paying the down payment as part of your EMI. Or when a builder says he will return your principal after three years with 24% interest, he is probably including his interest cost of paying you returns in a higher per sq. ft rate for the apartment. Remember, there is no such thing as a free lunch," said Billimoria.

Find out specific information on the levels of costs, how often they will occur and how they will be calculated and charged. This will help evaluate the impact of costs on the final returns and also compare between investments. For example, exit loads in mutual funds typically reduce with longer holding period. Ensuring that the holding period is at least as long as the period required to eliminate any exit load is one way of protecting the final value of the investment from a charge.

“For mutual funds, one can go through the fact sheet to find out the expenses of management for regular and direct schemes. You can also find the exit loads in the fact sheet,," said Praharaj.

For banks, one can visit a branch or website or call the customer care service to ascertain charges for deposits, advances and services.

There are some expenses that may be negotiable and comparable across service providers, such as advisers’ fees and commissions, brokerage costs and demat account maintenance services. Often, if you are taking a bouquet of services or expensive ones, some charges, such as service charge or account opening fee, may be waived.

Always, compare the fees charged and services offered before finalising the service provider.

While costs should not be the only reason for selecting an investment or financial service, it should be an important element in the decision matrix to avoid any rude shocks later. Small numbers can be deceiving, and over time, they add up to become a significant amount, which then bleeds the investment’s returns.