In the year 2012, SEBI directed mutual funds/Asset Management companies (AMCs) to provide a separate plan to investors for direct investments in mutual fund schemes. In this post, we discuss what regular and direct plans are all about and the difference between the two types of plans. Finally, we assess the impact of different cost structures of the two types of plans on the returns offered by the funds. We also discuss the procedure to invest in direct plans of mutual funds and impact of taxation on shifting from regular to direct plans.
What are regular and direct plans of mutual funds?
You can invest in a mutual fund scheme in two ways: directly with the fund house (direct plans) or through a mutual fund distributor (regular plans).
Regular plans are the norm. That is how you have been used to investing in mutual funds. Under regular plans, you invest in the mutual fund through a distributor or a channel partner. Investment from your regular distributor or online fund investment platforms such as ICICIDirect falls under regular plans. Expectedly, since an intermediary is facilitating a transaction, fund house pays them an upfront and a trailing commission. The actual commission paid can vary across schemes and even across distributors. Though the mutual fund does not directly charge you the commission, it gets paid from the fund only and thus it affects your returns indirectly.
Post SEBI directive, mutual fund houses started offering direct plans. Under the direct plans, you approach the mutual fund house directly to invest. Since there is no distributor involved, no commission is paid. Thus, the expense ratio is lower for direct plans as compared to regular plans.
In simple terms, expense ratio is a measure of cost that you pay to the fund house for managing your money. Expense ratio covers everything from fund management fees, operational and marketing expenses to distribution expenses. Keeping everything else same, a lower expense ratio means lower costs and hence better returns. Since everything else (portfolio, stock holdings etc) is exactly same in direct plans and regular plans, direct plans offer better returns than regular plans.
This is the reason NAV for direct plan for the scheme is higher than the NAV for a regular plan. For example, as on April 10, 2015, for HDFC Balanced Fund, NAV for direct plan was Rs. 112.57 while the NAV for regular plan was Rs. 110.58. Do not make the mistake of thinking that the direct plans are expensive. It is exactly the opposite. Both plans had started at the same level after SEBI directive. However, owing to better returns, NAV of a direct plan has nudged ahead. The difference will only widen since the direct plans offer better returns.
What is the impact on returns?
Though we have established that the direct plans offer better returns, we have not yet discussed the quantum of impact on returns. For the purpose of analysis, we consider top 10 large cap equity funds (returns over 5 year period). Funds, for which the expense ratio for the direct plans was not available on ValueResearch, have been excluded from the exercise. Index funds have also not been considered for the exercise. We took a simple average of expense ratio of direct and regular plans for such 10 plans. The average expense ratio for regular plans was 2.48% while for the direct plans; the average expense ratio was 1.84%. The difference is 0.64% per annum.
Let’s see the impact on absolute returns through the help of an example. We have assumed two different SIP amounts (Rs 10,000 and Rs 15,000), two tenors (10 and 15 years) and two levels of returns (8% and 12%). If return mentioned is 12%, we have taken return for regular plan at 12% and for direct plan at 12.64%.
You can see the power of compounding in full force. The difference between the absolute returns grows with the increase in SIP tenor. This makes the case for investing in direct plans of mutual funds so much stronger. In no way, do we mean that the difference in returns between the direct and regular plans will be 0.64% per annum. We have used the figure for illustration purposes.
The difference in accumulated wealth for the direct and regular plans is too high to ignore. To invest in direct plans of mutual funds, you just need to visit the nearest AMC/mutual fund office, fill a form and submit requisite documents (cheque, copy of PAN card, address proof etc). During your visit, you can request for online login credentials too. Subsequently, you can simply transact online. Most fund houses provide easy online interfaces for redemption of units and creation and cancellation of SIPs or even invest in any other fund from the same AMC. The only drawback is that, in case you want to invest in a fund offered by an AMC that you have not invested with before, you will have to visit nearest office of that AMC once to complete the documentation.
You can also shift your existing mutual fund investments from regular to direct plans. However, such transfer shall be considered redemption (from regular plan) and a fresh investment (into direct plan). Hence, capital gains tax and exit load implications may arise. Additionally, for investments which have a lock-in period (such as tax saving mutual funds or ELSS), your investments into direct plans will have a fresh lock-in of 3 years. So, anyone planning to switch from a regular plan to a direct plan should keep these elements in mind.
Considering all the points discussed above, we recommend that any fresh investments that you make in the mutual funds shall be through direct plans. For the existing investments, you may have to consider taxation, exit load and lock-in period before you make the decision to switch.
Update: December 28, 2015:
Contrary to what is mentioned above, it is not necessary to visit the nearest AMC office if you want to invest in direct plans of mutual funds. If you are KYC compliant, you can go to respective websites of mutual fund houses and start investing in direct plans. Go through the following post for more on this.
Deepesh is a fee-only financial planner and Founder, PersonalFinancePlan