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A costly churn

As a mutual fund investor moves from one scheme to another, she will have to bear some costs, writes Arnav Pandya.

india Updated: Sep 02, 2007 23:24 IST

There is a cost that comes with the churning of a mutual fund investment. While the mutual fund distributor gains from this activity in the form of higher commissions, not many know the exact impact that the investor will suffer when they undertake churning.

Here is a look at the various burdens that the investor will have to bear in the entire process and how he can go about reducing this unnecessary expense.

Churning

Churning is nothing but the process where an investor sells the existing mutual fund holdings and then shifts the same money to another scheme. The idea behind this act for the investor is to go towards a better performing mutual fund scheme, but even a strategy of letting the money lie for a longer timeframe can be a better idea as far as the overall performance is concerned.

Consider a case where an investor has put in his money in an equity-oriented fund and this has seen a 20-22 per cent rise over the next six to seven months. In this case, if the churn in the investment takes place at this stage where the existing investment is sold and the money is transferred to some other fund, there will be an impact for the investor on various fronts.

Exit load

With several mutual funds raising their exit loads as well as others introducing new ones, there is likely to be a charge that the investor will pay when he exits the existing scheme in a short period of time. There are various time periods for which the exit loads are applicable like six months, one year and so on. Thus, it can be applicable for an investor if he quickly sells off the investment. The shorter the time period for applicability of the load, greater is the chance to escape from the burden. This is the first expense that an investor will bear.

Entry load

The moment an investor enters another scheme, the cost of the entry load is something that he will have to bear. This can range between 2-2.25 per cent and hence this is a cost that will straight impact the investor. This raises the overall cost for an investor because if he had not done anything, then he would not have had to pay the cost that is now on him.

Capital gains

There is also the need for paying the short-term capital gains tax of 10 per cent on the sale of units in the initial scheme when this investment is sold within a year. If this was held for a longer tenure and sold after a period of say two years, then the capital gains would be long-term in nature and as such there is no tax to be paid. This raises the cost of transaction for the investor where the net figure is the amount that he has to pay.

When all the above costs are added, the extent of the burden how each switch of fund will impact an investor can be seen.

(The writer is a Certified Financial Planner)