Nav, Exit Load and Expense Ratio of Mutual Fund
In this edition, we are going to understand the terms of mutual funds like NAV, SIP, direct plan, exit load, expense ratio and others.
When we explore through the various mutual funds available in the market, we will first find terms mentioned on every mutual selling platform like NAV, Expense Ratio, Exit load, AUM size and others.
Let try to understand this important terms.
NAV:
NAV, which stands for Net Asset Value. This term indicates the price we have to pay to buy a unit of that particular mutual fund.
To better understand this, consider the following analogy. Imagine we have 100 people, investing 1,000 each in a mutual fund. The total amount the mutual fund now has is 1 lakh. The fund manager will go to the equity market and invest this 1 lakh in a company. The number of shares obtained by this investing in that company would be evenly distributed among the 100 investors of the mutual fund in the form of units. Here the NAV would be 10.
So for a NAV price of 10 for each unit, then each of the 100 investors would get 100 units each for 1,000 invested.
In the same way, we can calculate our holdings in a mutual fund by multiplying the NAV with the number of units you hold.
A point to be noted here would be that, NAV is a net value, but not a gross value. This means the costs incurred, if any, would be removed and then the final value of NAV is obtained.
If the 1 lakh invested received a profit of 50 thousand after a year, before you calculate the NAV, you must remove the costs of the mutual fund (we will get into the costs in a bit), say 10,000. Then total amount after profit and cost incurred would be 1.4 lakh. This would give us the NAV as 14.
Exit Load and Expense Ratio:
To let the elephant in the room out, every asset management company is running a mutual fund scheme to make money. And the costs involved in running the mutual fund are collected differently.
Almost every financial product available in the market have a cost attached to it. We might have the costs state explicitly, like for FDs, the banks calculate and remove the costs before they share the interest rate for maturity period.
For provides like mutual funds which are linked to equity market, we have cost expense ratio and exit load. An advantage of investing in mutual fund over the direct equity investment would be no front load. Meaning, you won’t have to bear any cost when you are buying the equity.
Since mutual funds are managed by experts, who intensively research a company before investing and handle the allocation of your money in different investment products, the mutual fund will charge you a fee called Expense Ratio.
Mostly, the expense ration would be from 0.5 percent of your investment amount or 3 percent of your investment amount.
This number would seem like a very small number, but it becomes a huge amount over a period of ten to twenty years.
It is recommended that you go for a fund which has lower expense ratio. As a thumb rule, anything in below 1.5 percent would be good.
Let’s look at the Exit load. To take care of the costs incurred when selling a mutual fund, an exit load would levied. This would also be used to strict you from exiting a mutual fund in a short period. Most of the mutual funds will not have an exit load after a year or two years of staying invested in a mutual fund.
As we can see, exit load is mostly to discourage us from exiting a mutual fund early and to make us invested in the mutual fund for longer time. The exit load is only levied when you exit the mutual fund, but not in regular intervals like expense ratio.
Make sure to select a mutual fund which has an exit load levied only for a period you are comfortable with. Except for few, almost all mutual fund would have less than 3 years period to levy an exit load charge. So you don’t have to worry about exit load if you are going to stay invested in a mutual fund for 3 years.
Direct Plan & SIP:
The cost structure of a mutual fund would decide if a mutual fund is a direct plan or a regular plan. A direct plan would cost us less than a regular plan. Always choose a direct plan when you invest in a mutual fund.
For a regular plan, you might have an agent/intermediary to work on your behalf, by this you would have to bear the cost of commissions or distribution expenses. In a direct plan, you would directly reach out a fund house and invest in the mutual fund by furnishing the documents required and completing the initial KYC required.
Since all the hassel of buying a mutual fund can be reduced by buying it online. Online platform make it easy to verify your details, documents and complete KYC, no agent is required, and you say commission fee. So always prefer a direct plan and avoid any extra cost of agent or distributor.
SIP, short for Systematic Investment Plan. Of all the things about mutual fund, SIP is the most misunderstood term. Let’s try to understand SIP.
At the end of the day, a mutual fund is buying a share or equity of a company. And the price for that equity is not the same every time. We only want to pay for what it’s worth or lower when we are buying equity(or in general anything). So investing a lump sum amount in a mutual fund would mean that we are buying the underlying equity whatever price the market is offering for us. But we are also not sure for ourselves that what would be the right price to pay for owing the equity.
When can circumvent this by averaging out our price. Say we pay 100 extra now and pay 50 less, later, and then pay 10 extra after a month or so and pay 160 less after two months. By this we are making sure that we are overpaying or underpaying. We are averaging out the price over a long time period.
This process of systematically planning out the investment every month with a certain amount is called Systematic Investment Plan.
Hence, SIP is not an investment product, it is a wise plan to invest in a mutual fund.
Prefer SIP always over investing in a lump sum amount if you are not sure about the price of the underlying equity.
Another advantage to SIP is, you would be investing on a monthly based, starting with an amount as low as 100 per month. So if you don’t have a huge amount at hand, SIP will do the job.
In conclusion, always choose a mutual fund which has lower expense ratio, lower than 1.5%, choose a direct plan and invest with SIP(monthly investment).
Until next time,
Peace out!