You should always invest in Direct Plans of Mutual Funds. Here is the reason why?

This post aims to highlight the benefits of avoiding the distributors/brokers (both online & offline) while investing in mutual funds and in turn investing directly with mutual fund companies.

Direct vs Regular Plans of Mutual Funds: Is there any difference in underlying stocks?

Mutual fund companies offer the option of direct as well as distributor route for investment in their schemes. Regulator has made it compulsory for all the mutual fund companies to offer direct investment option (direct plans) of each scheme to investors. The difference between direct and other plans (regular plans) of a mutual fund scheme is that in direct plan, the mutual fund company does not have to pay commission to distributors for bringing in the investor’s money. There is no difference in stocks where money is invested in direct and regular plans. Both plans have same investment manager and other team members.

Distributor Commissions:

Mutual fund companies pay commissions to distributors at the time of initial investment (upfront commission) and thereafter annually (trail commission) until the time the investor stays invested with the mutual fund. For any equity mutual fund scheme, the upfront commission is about 1.00% of investment amount and trail commission is about 0.50% to 0.75% of the investment amount. Further, if the mutual fund scheme has a long lock-in period during which investor cannot sell her investments, the upfront commission is increased accordingly. For example, tax saving equity link saving schemes (ELSS), which have a lock-in period of 3 years, usually have upfront commission of about 3.00% to 3.50%. (You can see details of commissions HSBC Bank India gets from different mutual fund companies, here).

How do commissions to distributors affect us as investors?

Mutual fund companies recover all the expenses incurred for running their schemes including distributor commissions, marketing & administration costs and brokerages paid to buy & sell shares etc., from the money which people like us have deposited with them for investment. The ratio of expenses to total investment money (assets) is called Expense Ratio and it varies between mutual fund companies and between different schemes of a mutual fund company.

In India, regulator has capped the expense ratio at 2.50% for equity mutual funds and 2.25% for debt mutual funds. Most of the mutual fund companies charge about 1.50% to 2.50% for their equity-oriented schemes. This money is deducted from the total assets of the scheme and then the remaining assets are used to calculate the net asset value (NAV) of the units of the mutual fund scheme.

If we invest directly with mutual fund companies in the direct plans and avoid the distributors, the companies save on the upfront & trail commissions and pass on the benefit to investors in the form of higher NAV for direct plans. Comparative higher NAV of the direct plans mean higher returns for those investors who invest in direct plans than regular plans of same investment scheme of same mutual fund company.

Below is the table, which reflects the difference between returns of the direct plans and regular plans of a few equity-oriented schemes of different mutual fund companies. This data is taken from Value Research on August 9, 2014:

Direct vs Regular Plans of Mutual Funds: Differences in one year returns:

The data clearly shows that the direct plans of almost all mutual funds schemes give higher return than regular plans of same schemes. The difference for most of the schemes is about 1.00% to 1.50%. However, for some schemes like Reliance Quant Plus Fund, it is surprising 2.51%!

One may argue that the returns of regular plans are only just a bit lower. Returns of regular plans: 38.63% (Reliance Invesco Business Leader Fund) and 42.55% (BOI AXA Equity Fund) are very good. Then why should one worry about 1.50% or 2.51%.

It needs to be stressed that the money in both plans, direct as well as regular, is invested in same stocks by the same investment manager and team members. Therefore, the risk, which you take by investing in both the plans, is the same. The difference in returns is only due to the savings the companies make by not paying commissions to distributors. Therefore, this difference in return is going to continue both in good times and in bad times.

The table reflects returns from August 2013 to August 2014 when equity markets and equity-oriented mutual funds have given very good returns. During this period BSE Sensex has increased by 34% (At August 9, 2013, BSE Sensex closed at 18,946.98 and at August 8, 2014, it closed at 25,329.14). However, we all understand that equity markets and equity-oriented mutual funds do not give very good returns every year. There would be times when returns are low or even negative. If during any year regular plan of equity mutual funds, give return of only 1.50% then the direct plans would give return of about 3.00%. This would mean almost double of the amount of return for same risk. Similarly, if regular plans report loss of 1.50% then direct plans may give 0% return and prevent loss of investor’s money.

More importantly, we should consider the impact of this difference in returns over long periods, as equity mutual funds are long-term investments.

Direct vs Regular Plans of Mutual Funds: Impact on future returns

If one starts monthly investment in any equity mutual fund scheme by a systematic investment plan (SIP) at age of 30 year and continues it until retirement at age 60 years, the higher return of direct plans can lead to substantial difference in final maturity amounts at retirement.

The table below gives data for comparison of investments in direct plan and regular plan for a monthly investment (SIP) of Rs. 15,000 in an equity-oriented mutual fund scheme over 30 years. Three scenarios of different returns by equity-oriented mutual fund are analyzed. It is assumed that direct plans will give a return of 1.50% higher than regular plans of the same mutual fund scheme. I have used Future Value (FV) function of Microsoft Excel to calculate maturity amounts for each case.

The above table clearly shows that investment in direct plans leads to significantly higher amounts at retirement than regular plans. The difference of 1.50% in returns, which was looking very small initially, over 30 years, has created huge difference in wealth one would have by investing in direct plan of an equity mutual fund scheme of his choice. It is to be noted here that money in both direct and regular plans is invested in same stocks by same investment team.

Therefore, I believe whenever one decides to invest in any mutual fund scheme, she should always invest in direct plan of that scheme. Not investing in direct plans amounts to leaving free money on the table. 

Conclusion:

Financially, it makes sense to convert all your existing regular plan investments to direct plans, as the difference in maturity amount is huge over long periods of investment. Small efforts today might give benefits of crores of rupees in future at time of retirement. Moreover, there is no incremental risk, which one takes by shifting to direct plans of same mutual fund scheme.

Have you shifted your mutual fund investments from regular plans to direct plans or have started investing in direct plans for new investments? Tell us about it and give your comments below about how you feel about it.

Why individuals have advantage over mutual funds in stock investing?

Dear Sir,

It’s really a thankless job you’re doing. I read all your posts through reader.

Though mutual funds keep a portion as cash, they would normally be compelled to buy fresh shares whenever new funds are pumped in. And this often happens more in a bull market. So, how can they follow the valuation part of the shares?

Can they keep a margin-of-safety after a DCF or any other type of valuation?

Regards,

Author’s Response:

Hi,

Thanks for your feedback & appreciation! I am happy that you found the articles useful!

You are right that mutual funds usually face a peculiar dilemma. They get more money for investment, when the markets are going up and shares are becoming expensive every day. They get more redemption requests and have to sell shares in bear markets when shares are becoming cheaper every day. This situation leads to mutual funds buying stocks when they are becoming expensive and sell stocks when they are becoming cheap. In the end, this process hampers the returns the mutual funds can generate for investors.

This is precisely the reason, I believe that an individual investor who does not have to face such challenges, can do very well in markets. She is not answerable to anyone and can buy stocks when prices are down.

Read: 3 Guidelines for Selecting Stocks Ideal for Retail Equity Investors

Regarding valuation part/margin of safety:

Valuation method does not have to depend on someone being a mutual fund manager or a retail investor. It is person dependent. Every investor has a personality and the valuation and stock selection methods varies from person to person. Some may like technical analysis, some like fundamental analysis. Some are growth investors, others are value investors and so on.

You should the following article about assessment of margin of safety for a company:

3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

Regards,

Do we invest in Mutual Funds?

Hello sir,

Thank you so much for a very good portal.

I would like to know whether you are investing only in direct stocks or also in mutual funds. If you are not investing in mutual funds what is the reason for the same.

After reading your blog about number of stocks to hold, I have finalized around 8 stocks & I am happy about it as I got around 14 % within 1 year even during this volatile period (I am holding them still).

I am confused whether I should continue my SIP in mutual funds or to stop (I am investing in sector funds SBI Pharma fund, UTI transportation & logistics fund & Franklin High growth companies fund).

Thanks in advance for your clarification

Author’s Response:

Hi,

Thanks for writing to me!

We am happy to see that you have started doing your own stock research and have built up a portfolio. All the best for the future.

We invest in mutual funds (only in equity linked savings scheme ELSS – Direct Plans) only to the extent it is needed to complete my 80C investment limit post factoring in the EPF contribution. Rest of our portfolio is investment in direct stocks.

We do not put additional money in mutual funds, as the purpose of equity mutual funds is to hire services of a fund manager to select stocks for us. If we believe that we can ourselves select stocks, then there is no point in bearing the costs of mutual fund, management fees etc. Such fees/costs are about 1.5-2% of portfolio value, which can be significant over long periods of investment horizon.

We believe that the fund manager of mutual fund is also a human being looking at same information/data to make investment decision about different stocks. There is no point giving fee to someone else for doing us, what we can do on our own.

Read: Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

Hope it clarifies your query.

Regards,

Vijay

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