Mutual Fund Mastery puzzles, solved step by step

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All topicsCompounding and time value9Statistics, correlation and diversification8Bond maths and duration10Performance measurement and returns8Costs and fee drag8Valuation riddles11Logic and numeracy brainteasers6Estimation and market sizing7Probability and expected value8NAV, units and fund mechanics7Risk, volatility and drawdown8Behavioural traps6Withdrawals and after-tax arithmetic4
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  1. 056An equity fund has 120% annual portfolio turnover and pays about 0.4% round trip in impact cost and brokerage every time it replaces a holding. Roughly how much return does it lose each year that never appears in the expense ratio?Costs and fee dragCoreFund research and ratingsIndian AMCs

    Try it first

    How much does the trading cost take from the return each year?

    Show the worked solution

    About 0.48% a year, roughly half a percent. Turnover of 120% means the fund sells and rebuys 1.2 times its portfolio in a year. Each rupee replaced costs one sale and one purchase, 0.4% together, so the drag is 1.2 x 0.4%. That cost shows up as a lower NAV, never as a line in the expense ratio, so the investor pays it without seeing it.

    Why does a cost this size not appear on the factsheet?

    Think of a shopkeeper who keeps rearranging the stock. The rent is printed on the lease, but every time he returns goods and reorders, the supplier keeps a small handling margin, and that never appears on any bill he shows you. The expense ratioThe annual charge for running a fund: management fee, administration, distribution and similar costs, shown as a percentage of assets. is the rent. Trading costs are the handling margin: brokerage, taxes on trades and the impact costThe amount a price moves against a large buyer or seller while the order is being filled. It is paid through a worse price, never through a bill. of moving prices, all paid through the prices the fund gets, so they land in the NAV and not in the expense ratio. Which explicit trading charges may be loaded inside the expense ratio is set by regulation and should be checked for the market you are in; impact cost is never there.

    Two costs come out of the return; the factsheet shows one9%10%11%12%13%12.5%Gross return-1.2Expense ratio-0.48Trading cost10.82%What you getTurnover x cost120% of the bookreplaced each yearx 0.4% per round trip= 0.48% a yearNot in theexpense ratio29% of total costAxis starts at 9% so the small bars can be read; the bar heights above 9% are to scale.
    A fund earning 12.5% gross loses 1.2% to its expense ratio and a further 0.48% to trading, so the investor receives 10.82% and about 29% of the total cost never appears in the expense ratio.

    How do you turn turnover into a cost without double counting?

    Portfolio turnoverThe share of a portfolio replaced in a year, usually measured as the smaller of purchases or sales divided by average assets. counts how much of the book is replaced. At 120%, every rupee of assets is sold and rebought 1.2 times in the year. Because the 0.4% already covers both legs of a replacement, the cost is simply turnover times the round-trip cost: 1.2 x 0.4% = 0.48%. The common slip is to say a replacement has a buy and a sell and double it to 0.96%, counting each leg twice. A fund turning over 20% of its book pays only 0.08%.

    The relationship
    hidden drag=turnover×round-trip cost=1.2×0.4%=0.48%\text{hidden drag} = \text{turnover} \times \text{round-trip cost} = 1.2 \times 0.4\% = 0.48\%
    turnoverthe fraction of the portfolio replaced in a year, 1.2 here
    round-trip costbrokerage, taxes and impact cost for one sale plus one purchase, 0.4% here
    What it says in wordsMultiply how often the book is replaced by what one replacement costs, and you have the yearly drag that the expense ratio does not show.

    Put rupees on it, because half a percent sounds small. Rs 10 lakh compounding for 20 years at 11.3% grows to about Rs 85.1 lakh; at 10.82% it grows to about Rs 78.0 lakh. The gap is about Rs 7.0 lakh, paid quietly. The limit of the estimate: impact cost depends on how liquid the stocks are and how large the fund is, so the same turnover costs a small-cap fund of Rs 20,000 crore far more than a large-cap fund of Rs 2,000 crore.

    Where candidates lose it

    The first lost answer is zero, from a candidate who assumes the expense ratio is the whole cost of owning a fund. The interviewer is checking whether you know that trading costs travel through the NAV, out of sight.

    The second is 0.96%, from doubling a cost that was already quoted round trip. Ask, or state, whether the 0.4% is per side or per round trip before you multiply.

    What the interviewer asks next

    • Why would a larger fund with the same turnover usually pay a higher round-trip cost?
    • How could you estimate a fund's trading cost from its disclosed returns and its index?
    • An index fund has 8% turnover. Roughly what is its hidden drag at the same cost per trade?
  2. 094An equity fund keeps 8% of its assets in cash earning 6% a year, while the stocks it holds return 13%. How much does the cash cost investors each year, and in what kind of market does the cash pay for itself?Costs and fee dragCoreFund research and ratingsIndian AMCs

    Try it first

    What does the 8% cash holding cost the fund in a year when stocks return 13%?

    Show the worked solution

    About 0.56% a year when stocks return 13%, and the cash pays for itself only when stocks return less than 6%. The cash earns 6% instead of 13% on 8% of the fund: 0.08 x 7 points is 0.56%, so the fund returns 12.44%. If stocks fall 20%, the same cash means the fund loses 17.92%, a cushion of 2.08 points. Cash is a cost whenever stocks beat cash and a cushion when they do not.

    Why is the cost the gap and not the whole return?

    Keeping some money in a savings account rather than a share portfolio does not cost you the shares' return; it costs the difference between the shares' return and the interest the account pays. Cash drag is the cash weight multiplied by the gap between what the stocks earned and what the cash earned, not by the stocks' whole return. With 8% in cash, 13% on stocks and 6% on cash, the fund loses 0.08 x 7, or 0.56 points, against a fully invested version of itself.

    Cash costs in a rising market and cushions in a falling oneStocks up 13%13.00%-0.5612.44%StocksCash dragFundStocks down 20%-20%-17.92%+2.08 cushionStocksFundCash helps only when stocks return less than cash, here 6% a year
    With 8% in cash at 6%, the fund trails its stocks by 0.56 points when they rise 13% but loses only 17.92% when they fall 20%, a 2.08 point cushion, so the cash costs money in rising markets and saves it in falling ones.
    The relationship
    Rfund=(1−c) Rs+c Rc=0.92×13%+0.08×6%=12.44%drag=c (Rs−Rc)=0.56%R_{fund} = (1-c)\,R_s + c\,R_c = 0.92 \times 13\% + 0.08 \times 6\% = 12.44\% \qquad \text{drag} = c\,(R_s - R_c) = 0.56\%
    cthe share of the fund held in cash, 8%
    R_sthe return on the stocks held, 13%
    R_cthe return on cash, 6%
    What it says in wordsThe fund earns a weighted mix of the two returns, and the drag is the cash weight times how far stocks beat cash.

    When does the cash earn its keep?

    Whenever stocks return less than cash. The breakeven is exactly the cash rate, 6% here: above it the cash costs, below it the cash helps. In a year when stocks fall 20%, the fund falls only 17.92%, because 8% of it earned plus 6% instead of minus 20%. Over ten years of 13% stock returns, though, the drag compounds: Rs 1 lakh grows to about Rs 3.39 lakh fully invested and about Rs 3.23 lakh with the cash, a difference of about Rs 16,500.

    Say why funds hold cash at all before judging it. Some is needed to pay redeeming investors without forced selling; some is new money not yet invested; some is a deliberate call that prices are high. The first two are a cost of running an open-ended fund; only the third is a market view, and it should be judged like any other bet, by whether it paid over a full cycle. A fund that holds a lot of cash and calls it caution is making a market-timing bet, whatever it calls it.

    Where candidates lose it

    The common slip is 8% of 13%, or 1.04%, which treats the cash as earning nothing. Cash in a fund sits in short-term instruments and earns something, so only the gap is lost.

    The second loss is calling cash a pure cost. The interviewer wants the other half: in a falling market cash cushions, and the breakeven is the cash rate itself. Give the 0.56% and the 2.08 point cushion together.

    What the interviewer asks next

    • How would you tell whether a fund's cash is for redemptions or a market call?
    • If the fund's stocks have a beta of 1.1, what is its overall market exposure with 8% in cash?
    • A fund could hold index futures instead of cash. How would that change the drag?