What are the Hidden Costs in Mutual Funds?

When you invest in mutual funds, the NAV and returns often take center stage. But lurking beneath these headline numbers are several costs that quietly eat into your returns over time. Understanding these hidden costs is crucial for making informed investment decisions and maximizing your wealth creation journey.

Let's uncover what these costs are, how they impact your investments, and what you can do to minimize them.

1. Expense Ratio (Total Expense Ratio - TER)

The expense ratio is perhaps the most significant cost in mutual funds, yet many investors overlook it. It's the annual fee charged by the fund house for managing your money, expressed as a percentage of your investment.

What it includes:

  • Fund Management Fees - Payment to the fund manager for making investment decisions
  • Administrative Costs - Record keeping, customer service, and operational expenses
  • Marketing & Distribution Costs - Expenses for promoting and distributing the fund
  • Registrar & Transfer Agent Fees - For maintaining investor records

Example: If you invest Rs 1,00,000 in a fund with a 1.5% expense ratio, you pay Rs 1,500 annually, regardless of whether the fund makes a profit or loss.

Typical Expense Ratios in India:

  • Active Equity Funds - 1.5% to 2.25%
  • Index Funds & ETFs - 0.10% to 0.50%
  • Debt Funds - 0.5% to 1.5%

New SEBI Regulations (Effective April 1, 2026): SEBI has introduced a restructured TER framework separating the Base Expense Ratio (BER) from statutory levies like GST, STT, and stamp duty. This brings more transparency to what you're actually paying. Index fund caps have been reduced from 1.00% to 0.90%, and brokerage limits have been slashed from 12 bps to 6 bps for cash market transactions.

2. Exit Load - The Early Withdrawal Penalty

Exit load is a fee charged when you redeem your mutual fund units before a specified holding period. It's designed to discourage short-term trading and protect long-term investors.

How it works:

  • Equity Funds - Typically 1% if redeemed within 12 months
  • Debt Funds - Usually 0.25% to 1% if redeemed within 3-12 months
  • Liquid Funds - Often zero exit load after 7 days
  • ELSS Funds - No exit load, but mandatory 3-year lock-in period

Example: If you redeem Rs 5,00,000 from an equity fund within 12 months with a 1% exit load, you'll pay Rs 5,000 as exit charges.

Recent Update: SEBI reduced the maximum permissible exit load from 5% to 3% in September 2025, providing additional protection for investors against excessive fees.

3. Securities Transaction Tax (STT)

STT is a tax levied by the government on the sale of equity mutual fund units. This is often overlooked as it gets deducted automatically.

  • Rate: 0.001% (0.01 per Rs 100) on the redemption value of equity-oriented mutual funds
  • Applicability: Only on equity funds, not on debt funds
  • Deduction: Automatically deducted at the time of redemption

While STT seems small, it adds up over multiple transactions, especially for active traders.

4. Stamp Duty

Since July 2020, a stamp duty of 0.005% is levied on all mutual fund purchases. This applies to:

  • Lump sum investments
  • SIP installments
  • Switches between funds
  • Dividend reinvestments

Example: On a Rs 10,000 SIP, you pay Rs 0.50 as stamp duty every month. Over 20 years of investing, these small amounts accumulate significantly.

5. Transaction Charges (Now Abolished)

Previously, Asset Management Companies (AMCs) could charge Rs 100-150 per transaction through distributors for investments above Rs 10,000. However, SEBI abolished these transaction charges from August 8, 2025, making investments more cost-effective, especially through direct plans.

6. Capital Gains Tax - The Hidden Impact

While not a mutual fund fee per se, capital gains tax significantly impacts your actual returns:

For Equity Funds (held for more than 12 months):

  • Long-term capital gains up to Rs 1.25 lakh per year are tax-free
  • Gains above Rs 1.25 lakh are taxed at 12.5% (post Budget 2024)

For Debt Funds:

  • Gains are added to your income and taxed as per your income tax slab
  • Indexation benefit has been removed for all asset classes

7. Indirect Costs You Don't See

Beyond the official charges, there are costs embedded in fund operations:

  • Portfolio Turnover Costs - Frequent buying and selling within the fund increases hidden transaction costs
  • Impact Cost - Large funds may face difficulty buying or selling without affecting market prices
  • Cash Drag - Funds holding excessive cash earn lower returns than fully invested portfolios

How to Minimize Hidden Costs

Here are practical strategies to reduce the impact of these costs on your investments:

  • Choose Direct Plans - Direct plans have 0.5% to 1% lower expense ratios than regular plans since there's no distributor commission
  • Consider Index Funds - Passively managed index funds have significantly lower expense ratios (0.1% to 0.5%)
  • Stay Invested Long-term - Avoid exit loads by maintaining recommended holding periods
  • Compare TERs - Within similar fund categories, choose funds with lower expense ratios
  • Avoid Frequent Switching - Each switch attracts exit load, stamp duty, and potentially STT
  • Use Tax-efficient Strategies - Plan redemptions to maximize the Rs 1.25 lakh LTCG exemption

The Real Impact: A Numbers Perspective

Let's see how these costs compound over time:

Scenario: Rs 10,000 monthly SIP for 20 years at 12% annual returns

  • With 2% expense ratio: Final corpus of approximately Rs 75 lakh
  • With 0.5% expense ratio: Final corpus of approximately Rs 95 lakh
  • Difference: Rs 20 lakh lost to higher costs!

This illustrates why even a small difference in expense ratio can have a massive impact on your wealth over the long term.

Leverage Your Mutual Funds Without Selling Them

At DhanLAP, we understand that redeeming your mutual funds to meet financial needs comes with multiple costs - exit loads, capital gains tax, and the opportunity cost of missing future growth. That's why we offer Loan Against Mutual Funds (LAMF) as a smarter alternative.

With LAMF, you can:

  • Access funds without redemption - Avoid exit loads and capital gains tax
  • Keep your investments growing - Your mutual funds continue to earn returns while pledged
  • Get competitive interest rates - Often lower than personal loans or credit cards
  • Maintain your financial goals - Don't derail your long-term wealth creation

Instead of paying hidden costs through premature redemption, use your mutual funds as collateral and access liquidity when you need it.

Final Thoughts

Hidden costs in mutual funds may seem small individually, but they compound significantly over time. Being aware of expense ratios, exit loads, STT, stamp duty, and taxes empowers you to make smarter investment choices. Always read the scheme information document (SID), compare costs across similar funds, and prioritize direct plans and index funds when suitable for your investment goals.

Remember, it's not just about how much your fund earns - it's about how much you get to keep after all costs.