Is your investment cost-efficient?

It is important to know the cost of acquiring and maintaining any asset class, as it can have an adverse impact on returns

You have to choose between two equity mutual fund (MF) schemes. One has an expense ratio of three per cent and has given a return of 20 per cent in the past year. The other fund has an expense of two per cent and returned 18 per cent. If both funds have similar track records and pedigree, most investment advisors would prefer the former, despite a higher expense ratio of 100 basis points (bps), because of better returns. And, cost of investment becomes secondary.

On the other hand, if there are two Nifty-based exchange-traded funds (ETFs), one charging one per cent and the other two per cent, the advice would be to go for the former because of the lower expense of 100 bps. “Though ETFs in India are known to outperform the index, called tracking error, it is safer to go for the one with lower cost because tracking error means that the fund manager is managing the scheme actively — something that can lead to significant losses in bad times as well,” says a fund manager.

In other words, cost of investment is important because the returns are hit. But, one cannot apply the cost parameter across all asset classes without taking into account returns, safety and other parameters. Says Hemant Rustagi, chief executive officer (CEO), Wise Invest Advisors: “In traditional products, such as fixed deposits (FDs), deep discounts and debentures, cost is irrelevant because returns are guaranteed. But, cost comes into play where returns are not guaranteed. For example, in an MF or insurance product, as the investments are being made on behalf of the person, it is important to know the cost.”

When costs are important: Costs become important when you are comparing like-to-like products. Like the above-mentioned example, cost is a differentiator when two schemes with similar returns, history and pedigree have to be compared. Similarly, as there isn’t a remarkable difference between, say, ultra short-term debt funds (liquid funds), the expense should be considered. “Ideally, once you have identified the top three or four funds in a category, compare costs to get best results,” adds Rustagi. (Evaluate the charges)

Then, when you are an insurance scheme, costs come into play. Costs tend to be higher in products that are hybrid. If you look at insurance products that come with an investment option (unit-linked insurance plans), the costs are far higher compared to an individual segregating the two. If an individual invests in a term plan (for insurance) and a mutual fund (for investment) separately, the costs will be significantly lower and returns will be superior (see table). Holding investments in physical form — as in the case of gold — rather than electronic or paper form (sovereign gold bonds) can also eat into your returns, due to costs.

Similarly, if you are buying a property as investment, it is important to look at both acquisition and maintenance cost because even after purchasing the property, there will be regular property tax. In the case of commercial property, it becomes extremely important. So, in certain circumstances, it might make sense to buy a smaller property while investing but in a location that will earn good returns vis-à-vis a larger one on the outskirts which might not give similar returns.

When to overlook: There are two funds with similar returns and there’s a difference of 50 bps to one per cent in their expense ratio. “The investor should opt for the one with an established record and coming from a fund house with a pedigree, even if it charges marginally higher,” says Prateek Pant, co-founder and head of products and solutions at Sanctum Wealth Management. But, if there’s a larger difference, that would mean the fund house is paying higher commissions to distributors, he adds.

Investors also have the option to invest in a mutual fund directly, which saves them the commission. The difference between the expense ratio of direct plans and those in which commissions are paid is around one percentage point. This means one per cent higher returns for investors. Over a long period, with compounding, there will be a significant impact on returns. “Though direct plans are cheaper, investors need to first assess whether they are capable of handling their own investments or need advice,” says Abhijit Bhave, CEO at Karvy Private Wealth. MF returns vary widely. In multi-cap funds, one-year returns are between four per cent and 34 per cent.

Beyond commission, taxation: “When evaluating costs, don’t just look at the commissions or charges. One has to also take tax into account when considering overall costs,” says Sriram Iyer, CEO at Religare Private Wealth. If you want to allocate 30 per cent of your portfolio to debt, MFs can work out to be a better option than FDs for those in the highest income tax bracket. While MFs have an annual expenses of up to 1.5 per cent, if an individual remains invested for over three years, the tax outgo will be marginal, considering the indexation benefit. Due to taxation, investing in a monthly income plan can turn out to be more expensive than an investor using an equity and debt fund separately.

Investors usually don’t look at the opportunity costs and cost of capital. During initial public offerings, investors leverage their existing portfolio to bet on big issues. “They borrow at a high interest rate to make gains on the listing day and move out of the stock. But, when the markets are doing well, they don’t consider the worst-case scenario,” Iyer says.