The entire concept of stock market exists because different people have different opinions – but if there’s one theory in finance that all experts agree upon, it’s that fees matter. The lower the costs of any given strategy, the better will be its performance.
In fact for long-term investors, the cost of an investment can be the single-biggest differentiator in final returns. Imagine doing a monthly SIP of ₹10,000 in a mutual fund for 20 years, and your investment has earned a CAGR of 15%. If the expense ratio was 2.5%, the investment would grow to ₹98.36 lakh – but if the cost was 0.5%, the final amount will be 32% higher at ₹1.31 crores!
But even though many of us look for deals, coupons, or offer codes when it comes to shopping online or ordering food, we rarely think of costs when it comes to investing. In fact, often times, investors aren’t even aware that they are paying a fee when investing in a mutual fund!
“The miracle of compounding returns has been overwhelmed by the tyranny of compounding costs”
Jack Bogle, the founder of Vanguard Group & the father of passive investing, said this when asked about the impact of investment fees. So first, let’s take a deeper look at how fees burn a hole in your investments.
Wait, what fees?
Mutual funds are not free, nor is any other investment product – different options have different associated costs:
- Stocks: the primary cost with buying/selling stocks is brokerage commission. Depending on the broker, this can be up to 0.5% of the traded value. Other standard taxes and charges associated with transacting stocks is detailed here.
- Mutual Funds: many investors think that mutual funds are free since they don’t directly pay anything, but that’s not the case. MFs have 3 associated costs: A
- Total Expense Ratio (TER): this is the primary cost, and includes management fees, operational costs, etc. Reflected as a percentage, it is charged annually on the total invested amount. For example, if the TER is 2% & the invested amount is ₹10 lakh, then ₹20,000 is paid in fees the 1st year. If the investment gains 20% and increases to ₹12 lakh at the end of 1st year, the fee charged next year will be ₹24,000 (or 2% of ₹12 lakh).
- Transaction charges: this may be applicable if the investment is made via a distributor. Learn more about this here.
- Exit Load: some funds may charge an exit load, usually 1%, if the investor withdraws the amount within 1 year. This is not applicable on all funds.
- Exchange Traded Funds (ETFs): the only cost charged by the fund is the expense ratio. There is also a brokerage and a bid/ask spread cost associated with transacting ETFs, since they trade on an exchange and require a brokerage account. Learn more about how these costs make ETFs fairer than Mutual Funds for long-term investors.
- smallcases: For most smallcases, the only associated fee is the brokerage. As such, rather than paying an expense ratio for merely investing, investors incur a cost only when they buy/sell – and not if they simply buy-and-hold. The ultimate fees charged is different across different brokerages, and for additional details, please check with your broker.
Why do costs matter?
What we save in costs, we make in additional returns. We already saw the example earlier, when a mere 2% difference in fees (2.5% vs. 0.5%) resulted in a 32% increase in returns! This happens because fees are deducted at the start of each year, and the effects of any saving is also compounded over the years.
If you invest ₹10 lakh, each year you pay ₹25,000 for Fund 1 (TER=2.5%) and ₹5,000 for Fund 2 (TER=0.5%), which is deducted at the start. If both funds make the same 10%, you earn an additional ₹2,000 with Fund 2 (10% of ₹20,000).
“The grim irony of investing is that we investors as a group not only don’t get what we pay for, we get precisely what we don’t pay for”
Returns cannot be controlled, but costs can be. This is exactly why thousands of investors across the world, including Warren Buffett, have continuously stressed on the need to minimise costs. And this is also exactly why we, at smallcase, believe in the virtues of low-cost investments. Happy investing!