• Part 1: What are mutual funds? Where do they invest?
• Part 2: Mutual funds, demystified
• Part 3: 6 advantages of investing in a mutual fund

We have seen the advantages of investing in a mutual fund. Now let us look at some of the risks and costs of investing in the same.

Risks of investing in a mutual fund:

The biggest risk of investing in a mutual fund is one of underperformance. When an investor decides to invest in a particular asset class, he typically expects to get the return that the benchmark of the asset provides.

For example, if someone is investing in large-cap equity stocks, he would expect to make at least as much return (with similar risk) as a benchmark index, say Sensex or Nifty.

Mutual funds try to maximise the returns on the funds invested through them -- but all of the funds cannot succeed an outperforming each other or the benchmark. Hence, some of them under-perform the benchmark.

Similarly, the cost of investing in a mutual fund (discussed below), eats in the returns. In high return years (like the last few years, where returns have been in the high 30% in equity, 2% costs may not make a material impact: however, at more moderate or negative returns, costs can be a big inch).

The other risk with mutual funds is 'style drift.' If you invest in a large cap fund and it begins to invest in mid cap stocks, or if you invest in a long term debt fund but it starts to invest a greater proportion in cash instruments, you might not the type of risk-return reward that you have been expecting.

Change of the fund manager can also introduce an element of risk into your portfolio. There is a wide debate as to whether investing is a science or an art: most authorities concede that it is a blend of the two. If so, the artist may contribute to the success of the returns.

Hence, if you invest based on the ability of a fund manager who decides to move on, it presents you with a risk. Change of a fund manager can also cause style drift.

Costs of investing in a mutual fund:

Typically there are three types of charges in a mutual fund: entry load, asset management charges and exit loads. As the names suggest, these charges are applicable when you invest, while you are with the fund and when you exit the fund, respectively. You also get hit by the 'buy-sell spread.'

Entry load:

An entry load is the charge that the fund charges you for marketing and distributing the fund to you. This money is typically paid to your mutual fund broker. This can range from as low as 0.25% (or lower) in case of debt funds to as high as 2.25% in case of old equity funds. Typically, new equity funds require a lot more marketing and distribution effort and in order to compensate your broker for selling you a fund based only on promises, the entry load is higher (up to 5%).

Now you may say that when you invested in the last new fund offering (NFO), you did not see an entry load. The Rs 1000 that you invested showed as 100 units of Rs 10 each -- how then was the entry load charged (or the broker compensated)?

Well, the fund company creates a Contingent Deferred Sales Charge (CDSC) which is the total expenditure that the company has incurred in launching the NFO. It amortizes this amount daily over the course of 3 to 5 years (the lock-in period) which reduces the NAV slightly every day (but with such a miniscule amount that it is hardly noticeable!)

Asset management charges:

While the fund house manages your money, it needs to incur costs in research, brokerage, salaries of hiring the best talent for you, office rentals and overheads, etc. In order to recoup such costs, the fund house charges you a certain percentage of your assets as asset management expenses.

In equity funds, this typically ranges between 1.5% to 2% of the assets per year while in debt funds, it is typically lower than 0.5%.

If you are investing for the long run, you will realize that a low cost fund (in its category) is the best choice for you. Incidentally, the lowest cost equity funds are 'index funds' which manage your assets passively by investing based on an index.

While academic research and mutual fund industry veterans (for example, John Bogle) show that these funds perform better and at lower cost over the long run, these funds seem not to have caught the fancy of investors in India.

Exit loads:

Exit loads are loads that the mutual fund charges you when you leave the fund. Exit loads are charged by some funds on a reducing basis on time: hence the load decreases as time passes. This promotes a long term investment from the investor. Also, the fund may charge you an exit load to recover some of the charges of from you.

Buy-sell spread:

When you buy a fund, you will typically be invited to buy at a premium to the prevailing Net Asset Value (NAV) of the fund. Similarly, while selling some funds might require you to sell at prices below the NAV. Hence, you get hit on both the sides. This spread is limited by SEBI to 6%, but typically the range is much lower, indicating a mature market.

When you buy a mutual fund, be careful: while these are great avenues of investment, you need to know the costs and the risks. Now that we have mastered them, we will look at the taxation aspects of the funds.

• See tomorrow:  Tax liability on your mutual fund

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus. He can be contacted at tilotia.akhilesh@parkfa.com