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June, 03rd 2008

  Over A 30-35 year working life, a 2-3 percentage point difference in returns can make a substantial difference to the corpus that one ends up with. To illustrate with an example, imagine two brother, Ajay and Vijay, who save Rs 5,000 each per month for 35 years. While Ajay earns 15 per cent return over this period, Vijay earns 18 per cent. What impact would this 3 percentage point difference make to the final corpus that the brothers end up with? While Ajay would end up with a corpus of Rs 7.34 crore, Vijay would end up with Rs 17.29 crore. Due to the power of compounding, the 3 percentage point difference would result in a stark 136 per cent difference in the final corpus.
This difference in returns can be produced not just by chasing high-return investments, but also by saving on the cost of investment. By following the cost-saving strategies outlined below, you can save a few basis points here and a few basis points there. Individually, they might appear small but over a lifetime they will make a substantial difference.
Minimise brokerage fee

Different brokerage packages are available in the market today. To choose the one that minimises your brokerage cost, look at your trading habit: are you a frequent trader whose transaction value is high? Or do you buy and hold stocks? Broadly, three types of packages are available:

Percentage of transaction value. Here,
the brokerage fee, which is a percentage of transaction value, ranges from 0.25-0.75 per cent the lower rate being applicable to higher transaction value.

Flat-rate charge.
Here a flat rate of about 0.4 per cent is charged irrespective of transaction value.

Subscription-based package.
Here you are charged an upfront fee and allowed to conduct a very high value of transaction within a fixed period of time. Provided you hit the ceiling, the fee can work out as low as 0.042-0.05 per cent. But remember, the transaction value must be really high.Clearly, investors whose total value of trading is very high should opt for the subscription package. Those who adhere to the buy-and-hold strategy should opt for either the flat rate package or the percentage-of-transaction-value package, depending on their exact transaction value.
A service tax on brokerage of 12.36 per cent is also levied.

Avoid high turnover of stocks

Though Internet trading has made it easy to buy and sell stocks, most day-traders end up losing money. As Delhi-based financial planner Surya Bhatia says: The greater the number of buy-and-sell decisions you make, the greater the possibility of making wrong calls, since such rapid-fire decisions would hardly be backed by any fundamental research, and your beginners luck would run out soon. Moreover, when you trade frequently, you increase your trading costs, and that makes it harder for you to beat a broad-market index over a three- to five-year horizon.

In addition to brokerage fee, you are also charged a security transaction tax (STT), which is 0.125 per cent on value of purchase or sale. Then there is a demat charge, which is 0.04 per cent for a sell transaction (buying is free).

Another big cost that frequent traders incur is short-term capital gains tax. If you sell a stock in less than 12 months, you pay this tax at the rate of 15 per cent, plus a surcharge of 10 per cent (on income greater than Rs 10 lakh) and a cess of 3 per cent. Selling a stock after holding it for a year means you realise long-term capital gain on which the tax is nil.

Undertake rupee cost averaging

Whether buying stocks or mutual funds, spending a lump sum amount at one go is not a good idea. A better strategy, which lowers your cost of purchase, is to use a fixed amount of money to buy stocks or fund units at regular intervals. Especially in a volatile market, this allows you to lower your cost of purchase.

Rupee cost averaging should become a habit. Only when the markets are going up vertically does rupee cost averaging not work. But over the long term markets go up and also come down, so it works well, says Bhatia.

Fund houses offer a facility called the Systematic Transfer Plan (STP) wherein if you invest a lump sum, it is first invested in a liquid fund. Then a fixed amount is periodically transferred to the desired equity fund to take advantage of rupee cost averaging. These days fund houses offer a monthly, fortnightly and even a daily STP. More conservative the investor, more frequent should his STP option be. When you have more points of entry, your returns take a hit but the downside also gets protected, says Bhatia.

Buy no-load funds

Now that Sebi has allowed direct investment, either online or at the mutual funds office, avoid investing in mutual funds via the broker. This allows you to save on the the entry load, which ranges from 1 per cent to 2.25 per cent.

Go for low-cost funds

Although this may be true for other products, high fees/charges dont necessarily ensure you a good performance in case of mutual funds. In the debate over whether to invest in diversified equity funds or index funds/exchange traded funds, a large number of retail and institutional investors in developed countries have shifted in favour of index funds and exchange traded funds (though they have yet to catch on in a big way in India). There are two reasons for the shift.

The foremost is cost. In India the expense ratio of equity diversified funds ranges from about 1.56-2.37 per cent. For the large majority it is 1.92 per cent and above. Well-run index funds, on the other hand, charge an annual expense ratio of about 1 per cent. (Some index funds also have a higher expense ratio of up to 1.5 per cent or more. Avoid those.) Also, when investing in an index fund, look closely at the tracking error (the margin of difference between the returns from the benchmark index and the index fund). Opt for funds that have a low tracking error.

To take care of the problem of tracking error, and to lower your costs further, you could opt for an exchange traded fund. Says Pune-based financial planner Veer Sardesai: Exchange traded funds do a better job of tracking the index. Their expense ratio is lower at about 0.5 per cent per annum. You also pay a one-time brokerage fee at the time of purchase.
If diversified equity funds could consistently outperform their index, then the extra 1-1.4 per cent expense ratio (over an index fund) would be worthwhile. But predicting in advance which funds will consistently beat the index over long periods of 5-10 years is nearly impossible.
For investors who are looking to invest money in equity to meet long-term goals, such as retirement or childrens education, an index fund or an ETF is the best option, says Veer Sardesai, a Pune-based financial planner.

In India, however, it may not be possible at present to make an entire mutual fund portfolio out of index funds and exchange traded funds. As Bhatia says: Given the chance, I would make portfolios entirely out of index funds and ETFs. But where are the index funds and ETFs for mid and small-cap stocks? So for the present one will have to use a combination of passive and actively managed funds.

Avoid early exit

Making an early exit from mutual funds can also cost you a packet. Most equity funds charge retail customers an exit fee, which is about 0.5-1 per cent if you exit within six months. Some funds also charge a 0.5 per cent exit fee if you exit within 6-12 months.
As the saying goes, Money saved is money earned. Being vigilant about costs will make a substantial difference to your net returns over your lifetime.

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