Identify good mutual funds yourself that beat the benchmark by at least 3 to 4 percentage points
A 10 bps cost over a 10-year period will reduce your total corpus by less than a percentage point
What would your face look like if you realised that your retirement corpus will lose about a third of its value due to the costs you’ve paid your mutual fund? You’ve begun to invest in mutual funds and collectively are pouring more than ₹ 1 trillion a year into equity mutual funds through SIPs. A mixture of reasons including successful awareness campaigns, low returns on real estate, gold and fixed deposits, better access through fintech and a big regulatory push towards making mutual funds safer for you caused you to invest almost ₹ 8,000 crore a month in these funds.
Most of you hopefully understood the magic of compounding and are committed to staying the long haul with the investment, but what you need to know is that compounding can multiply returns as well as costs causing very different outcomes for your money. A quick update on the costs you pay in a mutual fund: you don’t pay any commission on sales to an agent and a ₹ 100 investment goes to work fully. Unlike a traditional insurance plan, for example, where ₹ 60-65 goes to work and the rest as commission to the agent, a mutual fund is allowed to put all its costs under one head called the expense ratio and the regulator puts a limit on how much a mutual fund can charge. These expense ratios, therefore, range from about 10 basis points (one-tenth of a percentage point) to about 2%. It matters very much if you are invested in a mutual fund that costs you 10 bps or 2%.
A 10 bps cost over a 10-year period will reduce your total corpus by less than a percentage point. Over a 20-year period, it will reduce your money by just over a percentage point. And over a 30-year period, it will cost you almost 2% overall—in other words a ₹ 10 crore retirement portfolio will be ₹ 9.8 crore. Run the same numbers using a 2% cost per year, and your money reduces by 9% over 10 years, 20% over 20 years and a huge 32% over 30 years—or the ₹ 10 crore corpus will be worth just ₹ 6.8 crore due to the higher cost.
We know that an exchange-traded fund or an index fund are cheaper mutual funds that mimic an index. Since there is no cost of stock analysis and trading, mutual funds are able to whittle costs down to a wafer thin 10 bps or even lower. But what you get is the index return—say the Sensex or the Nifty. Managed funds, or funds where the fund manager takes a call and picks stocks cost higher—around the 2% mark. But unless they are able to beat the benchmark and give you at least 2 percentage points over the index, they cost you more than they benefit you.
So should you rush into index funds or ETFs? No. Because compounding works both ways. If your fund is able to give 4 percentage points over what the index fund or ETF gives, then over a 30-year period you will have more than double the money you would have had in an index fund. Indian fund managers have done quite well in beating the indices over the past 20 years. However, the extra return that fund managers are able to get in large-cap funds is coming down, but is still quite good in other categories of funds. Don’t look at one-year returns, but at least five-year returns to see the extra return over the benchmark.
If you are able to identify good mutual funds yourself that consistently beat the benchmark by at least 3 to 4 percentage points, it is worth your time to search for and invest in these schemes. Or if you work with a planner, ask to see the returns over time and compare these to the benchmark. Ask to see the pre- and post-cost returns. If you cannot do any of these, then you are better off in an index fund or ETF that just mimics an index. You can build a portfolio that has several kinds of ETFs to give the benefit of diversification. At the minimum, you will have a broad market index-linked fund, a mid-cap and a small-cap-linked fund. Remember to give a larger allocation to the broad market index fund and use the mid- and small-caps as a returns kicker. And do look at the expense ratios carefully—they matter.
Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation