Article Synopsis: All mutual funds have two plans Regular and Direct. Direct plans give higher returns every year because investors do not have to pay commissions. Despite this, nearly 90% of retail investors invest in Regular plan mainly due to lack of awareness. Investors can now transact in Direct plans through platforms such as ORO.
What are direct plans in Mutual funds?
In 2013, SEBI announced that every mutual fund scheme will need to have two plans. One would be the regular plan which had existed till date. In addition, mutual funds had to introduce a direct plan of the same scheme which would be similar to the regular plan in all respects but would have a lower expense ratio (i.e. fees you pay the mutual fund). This is because when you invest in the direct plan, there is no distributor involved and the commissions that mutual funds have to pay distributors go away.
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Paying lower fees on exactly the same fund directly translates into higher returns for investors. The difference between the expense ratio of regular and direct plans can be as high as 2% for some mutual funds (especially equity funds which are the darling of retail investors). On an average, the expense ratio of regular plan across mutual funds is 1.73% and the expense ratio of direct plans of the same mutual funds is 1.06% i.e direct plans are cheaper by 0.66% or a discount of nearly 40%!
Does the difference in expense ratio matter?
A difference of 1-2% in returns may not seem much at first glance. However this extra amount is being paid to the distributor every year. When combined with the power of compounding, paying commissions can put a big hole into your final earnings.
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While we discuss specific examples later, the difference that commissions can make can be gauged from the fact that the smart money investors in India (i.e. large institutions, corporates and similar professional investors) have already migrated almost completely to direct investing. After just 2 years of introduction, 70% of smart money investments happen in direct plans.
Difference in returns for an investor with a Lumpsum investment amount
As an example, suppose you had invested Rs. 10 lakhs at the beginning of the period in a fund in which the direct plan has an expense ratio of 1% and the regular plan has an expense ratio of 2%. Further assume that the fund earns a conservative return of 10% before costs. Then at the end of 10 years, difference in your earnings between the two plans will be Rs. 2.1 lakhs (Regular plan corpus 21.6 lakhs vs. Direct plan corpus 23.7 lakhs) or more than one-fifth of your initial investment corpus. After 20 years, with the compounding, the difference will be a massive Rs. 9.5 lakh (Regular plan corpus 46.5 lakhs vs. Direct plan corpus 56 lakhs) or nearly your entire initial investment corpus!
For a complete picture on how much you would pay in commission every year, visit our blog (http://bit.ly/directmfs)
Difference in returns for a SIP investor
SIP investing has become very popular and most SIPs are held for relatively long periods of time like15-20 years. Over these long horizons, the choice between Regular and Direct Plans can really make a massive difference. Further in the case of SIP, the commissions are charged on the entire accumulated corpus, not just that year’s invested amount. So the commissions that you pay on your SIP keep going up every year
Consider the following example:It is a monthly SIP i.e. where new investments are made every month. Amount invested per month: 20,000. Like before, pre-cost returns of the fund is 10%and regular plan and direct plan expense ratios are 2% and 1% respectively. So post-cost returns of the fund will be 8% and 9% for the Regular and Direct plans respectively. Also we will assume that returns are uniformly distributed in the year, soRegular Plan returns are 8%/12 = 0.67% every month and Direct Plan returns are 9%/12 = 0.75% every month.
Under these reasonable assumptions, by year 10 an investor would have paid out commissions equivalent to his or her annual investment amount (Regular plan corpus: 36.6 lakhs Direct Plan corpus: 38.7 lakhs Commissions: 2.1 lakhs). And God forbid if they remain invested for 20+ years then they would pay out more in commissions in any single year than what they are actually putting in! (Regular plan corpus:1.18 cr Direct Plan corpus: 1.34 cr Total Commissions paid till date: 16 lakhs Total Commissions in year 20 itself: 2.4 lakhs)
For a complete picture on how much you would pay in commission every year, visit OUR BLOG
Maybe I am already buying direct plans?
Unlikely. Only 10% retail investors have invested through direct plans. There are a number of reasons for this. First and foremost is the lack of awareness among retail investors about direct plans. This has to do in large part with the fact that the distributors, who are closest to investors, have no incentive to promote direct plans. In fact many of them market their services as “free” to the client, conveniently overlooking the fact that they get paid every year from the investor’s money, even though it is via the mutual fund.
A second reason is that so far it has been difficult for retail investors to invest in direct plans. The main way of doing this has been by maintaining separate accounts with each mutual fund company which is cumbersome.
Finally many retail investors are also scared away from direct investing by distributors and platforms which claim to offer expert advice that investors will miss out on if they go direct. Professional financial advice is important and can make a big difference to returns but the important question to ask is Is commission-based model the best way to get investment advice? Mis-selling i.e. selling investors the highest commission products is the biggest flaw with this model. The second question is whether that advice should actually cost 2% per year. Instead by going direct, investors can use just a part of the saved commissions to hire an unbiased, fee-based advisor whose incentives will be aligned with their own.
Investing in India is all set to change with - India's first direct funds platform. For the first time ever retail investors can transact in direct plans with the same convenience and level of service as standard plans. For investors looking to further enhance returns with financial advice, ORO also has an online fee-based advisory platform. Invest with ORO and experience the difference that truly low cost investing and unbiased, good quality advice can make to your returns.
Author: Swati Aggarwal
Swati co-founded ORO Wealth after 5 years of experience at Nomura (London and Singapore), where she was advising some of the largest global institutions on asset allocation and market timing. Prior to that, she did her MBA from Indian Institute of Management, Bangalore and Economics (H) from St. Stephen’s College, Delhi.