Low-cost financial products help you accumulate higher returns as a penny saved is a penny earned.
In an interview with Money 9, Gaurav Rastogi CEO and founder of Kuvera, an online investing platform, decodes the cost structure of all your investments.
Why is it important to look at the cost structure of investment?
In investing returns are always an expectation. So what that means is it’s something that you want to get in the next three or five years, but cost is a certainty. You have to pay the costs year in and year out, whether it is your mutual fund cost, whether it is your broking costs or whether it is your demat account costs. Returns are an expectation. If you’re lucky you will get them, or if you’re good, you will get them. But costs are a certainty. So people should definitely look at costs very closely when investing.
Mutual funds are now very popular. Can you elucidate about the cost involved when investing in mutual funds?
Mutual funds are fairly straight forward as there are a bunch of smaller costs like a 0.05% stamp duty. But for the most important part is what’s called a total expense ratio. Total expense ratio is the management fee that the portfolio manager or the asset management company charges you for managing that mutual fund.
Now, what do you get in return for paying that expense ratio? If it’s an active fund, you get fund management from a fund manager, you get their services. They are going to kind of decide which stocks to buy and what stocks to sell. Expense ratios in India can vary anywhere from 0.1% to as high as 2.5%.
Is the cost different for direct and regular plans?
What used to happen before 2013, just to give some historic context, mutual funds were distributed products. So effectively, what meant was that person who comes to you and says, you should buy this mutual fund, or you should now move to this mutual fund. You will not paying them anything directly. The mutual fund company would pay them a portion of the expense ratio. So in 2013, SEBI said we need one more version of mutual funds, which doesn’t have these commissions. So effectively your returns are higher. So one way to think about this is if you buy a fund, a direct plan, you will pay an expense ratio of 1%. And if you buy fund a regular plan, you will pay an expense ratio of 2.5 percent. Now the most important thing here to realize is that all of these costs are coming out of your pocket. If you’re paying less expense ratio, you are keeping more of the returns.
Is a passive fund cheaper than active fund and how does it work?
Passive funds are cheaper, but let’s first see what are active and passive funds. Active fund is a fund where you have a portfolio manager. The portfolio managers sole purpose is to help you get better returns. They have a benchmark and their goal is to beat that benchmark. A passive fund on the other hand basically says, that the benchmark itself has a great risk and return profile. So we will just track that benchmark. So simple example, if you have a large cap fund, most likely the goal will be to outperform the Nifty 100 or may be Nifty 50, depending on how the fund is set up. But you can alternately buy a Nifty 50 index fund, which would be called a passive fund and you would get the same risk return profile as a Nifty 50 index. Now the cost saving comes because for an active fund, you need a portfolio manager. You need an army of analysts who are going to then look at the market, we’re going to figure out which stocks are going to perform better. There’s a lot of work involved in figuring out which companies are good. That’s one part of the big puzzle, but you have to also figure out what’s the right time to buy them. So you need all these people need to be paid. So the cost for an active fund is usually higher.
If you look at large cap space, the average expense ratio on the direct plan side would be somewhere around 1% while for a Nifty 50 index fund, the cost would be like 0.1%. Because in a Nifty 50, you don’t need a fund manager, The index itself is your fund manager. You just mimic whatever is in the index and you let the market decide which stocks you’re buying and with stocks you’re selling it.
And research actually shows that, um, for large cap and, and to a large extent for mid cap, it’s very hard for active fund managers to beat these passive funds over long periods of time. Any water active and passive funds.
Which product gives the best return-to-expense ratio?
If you look at higher return and low cost, index funds of course will always win out because of just the cost differences. A passive fund that just tracks an index does not require a portfolio manager, does not require an army of analysts to figure out what stock to buy with stock to sell. It will on average have better returns to expense ratio for you.
