Mutual Funds: Choose direct plans over regular plans

The difference between the expense ratio of regular and direct plan is the actual commission received by the investment advisors or brokers.

By Parthajit Kayal

Mutual fund investment through systematic investment plan (SIP) has been marketed by financial advisors, brokerage houses and investment advisors for the last few years. After the stock market fell because of Covid-19, many agents sold different mutual funds schemes to new and existing customers by calling it as now or never time to invest. While I do not deny that enrolling for a SIP during a bear market is probably a good starting point for the long term retail investors, I harbour doubts about the schemes offered.

Direct and regular plans

After 2013, every mutual fund scheme is sold in two different categories: regular and direct. Both categories refer to the exact same scheme in terms of investment made. They are also run by the same fund managers but sold for two different prices. It is very similar to buying a bottle of packaged drinking water from a normal shop near your house and a shop in the airport. The same bottle of water but sold for two different prices. Regular plans are sold at a higher price as mutual fund companies pay a certain percentage to the broker as distribution fees every quarter. On the other hand, for ‘direct’ plans, investors get the full benefit as no commissions are paid to the distributors.
Investment advisors and brokerage houses will never tell you about the difference in prices clearly. If you ask them about the difference between these ‘regular’ and ‘direct’ plans, they will say that they earn a very small fee or commission (lesser than 1%). They will tell you that these commissions do not matter in the long run and show you some added advantages of investing with them in regular MF plans. Is the commission really small and with no significant effect on long term returns? Let us look at this carefully.

Expense ratio

The difference between the expense ratio of regular and direct plan is the actual commission received by the investment advisors or brokers. Investors lose this percentage of their investment value every year. The commission percentage could be as high as almost 2% in some schemes. Although the average commission percentage may seem low at 0.70%, it could lead to a large amount of loss in the long run. Now let us look at our investment value assuming a 1% average commission for the brokers.

Let us understand with an example. For instance, ABC invests in regular mutual fund schemes via a monthly SIP of Rs 10,000. XYZ, who has some knowledge about mutual funds’ expense ratio, chooses the direct plans of the same scheme. Considering a realistic assumption of 12% average annual returns and 2% and 1% expense ratios for the regular and direct funds respectively, ABC will have much lower investment value than XYZ. In fact, the longer the investment period, the larger will be the magnitude of loss.

For a monthly Rs 10,000 investment over a 30-year period, investors lose almost Rs 43 lakh by investing in a regular fund instead of a direct fund. If ABC had invested Rs 1 lakh every month then he would have lost Rs 4.5 crore. A difference in 1% commission does not seem much but makes a huge difference in the portfolio value over the longer term. Therefore, investors should avoid investing in regular mutual fund schemes and instead go for the direct scheme. Since the last two years, many fintech companies are offering good platforms to buy direct mutual fund schemes at very low or zero cost. Investors can make use of them.

The writer is assistant professor, Finance, Madras School of Economics