A mutual fund is a way to invest money where many people pool their money together. This combined money is then used to buy a mix of stocks, bonds, or other investments. Many of us see mutual funds as an option to create wealth. But how do mutual fund companies make money? Let us have a look:
1) Expense ratio
Mutual fund companies charge investors an annual fee known as the expense ratio. It represents a percentage of the fund’s average Net Asset Value (NAV), which reflects the total value of the fund’s assets.
This fee comes out of the fund’s assets, thereby reducing the returns that investors get. For example, if a mutual fund has an expense ratio of 1.5%, 1.5% of the fund’s assets will cover various expenses over a year.
The fund manager’s fee pays the professionals who decide how to invest the fund’s money. Additionally, the administrative costs cover things like keeping records and customer service and marketing and distribution expenses cover promoting the fund and paying financial advisors or brokers who sell it. All these fees help the fund run smoothly and effectively.
Investors do not pay the expense ratio as a separate charge; the fee is deducted directly from the fund’s assets. This means it reduces your returns regardless of the fund’s performance. Consequently, a higher expense ratio means lower returns.
Therefore, when you choose a mutual fund, you should check the expense ratio along with other performance measures to ensure you are making a smart investment.
2) Exit load
Mutual fund companies also charge an exit fee, known as an exit load. This fee applies if investors leave a scheme before a certain period, usually ranging from a few months to 1-2 years. The goal is to discourage short-term trading and keep the fund stable.
The exact amount of these charges can vary. Each mutual fund company sets its own rules for exit loads. So, you might see different exit load percentages depending on the fund.
The company deducts the exit load from the money you receive when you leave the fund. For example, if you withdraw your investment early and the exit load is 1%, the company will subtract this 1% from the amount you receive.
Understanding the exit load is important because it can significantly affect the amount of money you get back if you withdraw your investment early.
This fee encourages long-term investing and fund stability but can also lower your returns if you exit the fund early. Therefore, when choosing a mutual fund, consider the exit load to make the best decision.
3) Entry load
A mutual fund may charge you a fee to buy its units, known as an entry load. This fee, like the exit load, varies between different Asset Management Companies (AMCs) and funds. The entry load is calculated as a percentage of the fund’s Net Asset Value (NAV).
The percentage of the entry load can differ depending on the fund’s and AMC’s rules. Therefore, it is important to check the entry load before investing.
This fee is deducted from your investment amount. So, if you invest $1,000 in a fund with a 2% entry load, the company will take $20 as the fee, and $980 will be used to buy the fund’s units.
Some funds charge an entry load, while others do not. Consequently, compare different funds and their entry loads to reduce costs and get better returns.
It is important to note that since 2009, the Securities and Exchange Board of India (SEBI) has prohibited the practice of charging entry loads.
4) Units transfer
If you decide to transfer your mutual fund units to a different fund within the same fund house, you will have to pay capital gains tax. Several factors like the type of mutual fund and your income tax (I-T) slab determine this tax.
When you transfer units from one fund to another, the transaction counts as a sale of the old units and a purchase of new ones. So, any profit from this transfer is subject to capital gains tax.
Furthermore, the type of mutual fund affects the tax rate. For example, if you hold equity fund units for more than one year, the gains are long-term and taxed at 15% if they exceed a certain amount.
Your income tax slab determines the tax rate for short-term capital gains. If you hold the units for less than one year (for equity funds) or less than three years (for debt funds), the gains are short-term and taxed according to your income tax slab. Therefore, people in higher income brackets may pay more in taxes.
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Moreover, other factors like surcharges and cess can increase your total tax amount. Consequently, calculating the exact tax can be complicated. So it might be helpful to consult a tax professional.
Final words
Mutual funds offer a convenient way to invest, but it is essential to do your homework. Understanding how mutual fund companies make money is crucial for making investment decisions. With the right knowledge, you can use the maximum potential of mutual funds to achieve your financial goals. So, stay informed, stay patient, and let your investments work for you over the long term.
