Mutual Funds are Costly, Invest in the Index

Many of you, I hope, must be investing in mutual funds. That’s the safest choice for people who want to get in on the action in the stock markets without having any knowledge about stocks and companies. But I believe that mutual funds are costly even for the ‘know-nothing’ investor, who doesn’t know anything about playing with stocks and the stock market. They are better off investing in Index mutual funds or even better, investing directly in the stocks that make up the Index.

First, lets consider the Fees mutual funds charge in India. There’s the 2.25% Entry load, which is the fees that the mutual fund house pays the broker who made you buy the mutual fund. Then there’s the expense ratio of 2-2.5% per year, which is the yearly fees the mutual fund charges you for using their services. This expense ratio is adjusted in the daily NAV that the mutual fund quotes at. So if you stick with the mutual fund for a year, you would be paying ~5% to the fund. If your fund earns 20% returns in a year, you would only get 15%.
Imagine what the expense ratio (of 2.5%) does to your profits over the long term. Lets say you invest Rs. 1000 for 40 years and get about 10% averaged return on your money annually, this should give you about Rs. 45,259. But with a mutual fund, your annual return would be 7.5%. Your Rs. 1000 would only become Rs. 18,044 which is a difference of 60%. This 60% is taken by the fund.

But you say that it's worth it. The fund managers give you Professional Management of your money for this fees. You get better returns on your investment, right?…Wrong!
Almost all studies undertaken on this subject say that there is no correlation between high fees and high returns. The US Securities and Exchange Commission's website says:
“Higher expense funds do not, on average, perform better than lower expense funds."
What that essentially means is that the fees you’re paying doesn’t guarantee better returns. You’re better off investing in lower expense funds.

Index Funds, mutual funds that invest only in the stocks of an Index, like the SENSEX, are known for their low expense ratios and no entry loads. But that’s not all they’re known for. Index Funds (in the US) have been known to beat most mutual funds over the long term (3-5 years or more), which goes to show that the “professional management” of mutual funds isn’t all what you hoped for. The low expense ratio in Index funds is because all what Index fund managers do is put their money in the Index constituents, stocks that make up the Index, in the appropriate ratio as in the Index, and then go to play golf. If the Securities and Exchange commission changes some stocks in the Index, they come and do the same changes. Because of the low expenses, you are better off investing in Index funds. They earn better returns and charge you lower fees. E.g. Franklin Templeton Index Fund - Expense Ratio 1%.

But can’t you do what the Index Fund managers do? Can’t you put your money directly in the stocks that make up the index and then go to play golf?
Nope, you can’t. Golf is difficult to learn.
But you can very easily invest directly in the Index stocks. This way, you would avoid paying any management fees and would pay only the brokerage. To invest in the Index: Open a DEMAT account with a reputed bank like ICICI or HDFC. Look up the Index constituents break up on Google or look at the constituents of an Index fund like the FT Index Fund. Invest in each stock based on the ratio of each stock in the Index. You would avoid Mutual Fund fees altogether. But stay invested for the long term, atleast for 3-5 years (a lifetime would be ideal). Don’t let stock market crashes scare you.

So until you know how to pick stocks and calculate the value of companies, "Index Investing" and Index funds is the safest way to invest. This is what I’m going to do.

P.S.
Index funds haven't done well in India till now, but it might change in the future as the Indian market starts becoming efficient.
For another point of view specific to India, see this article:
http://www.valueresearchonline.com/story/storyview.asp?str=9040