Back in 2012, SEBI had come out with several reforms which included the introduction of direct plans in mutual funds.

Starting from January 1, 2013, every mutual fund in India comes in two variants – a Regular Plan and Direct Plan. Both versions are the exact same scheme, run by the same fund managers investing in the same stocks and bonds.

So, the question is, which plan is better for you: direct or regular plan?

Lets look into these two variants in detail.

Difference between regular and direct plan

Here are the 5 key differences between these two variants of mutual funds.

1. Definition

Direct plan funds are those mutual funds where the asset management (AMC) or mutual fund companies do not charge distributor expenses, trail fees, and transaction charges.

Regular plan funds are traditionally mutual funds that have been sold through brokers and intermediaries.

The commission that they earn by selling mutual funds is added to the expense ratio of the fund.

2. Difference in expense ratio

Direct plan funds have expense ratios which are much lower as compared to regular plan funds.

Have a look at the difference in the expense ratio of some popular mutual funds in two variants.

Fund Name Expense Ratio – Regular Plan (%) Expense Ratio – Direct Plan (%)
HDFC Small Cap Fund 2.14% 0.54%
SBI Bluechip Fund 2.35% 1.18%
L&T Low Duration Fund 1.03% 0.56%
Indiabulls Liquid Fund 0.17% 0.07%

*The expense ratio is as observed on 18th September 2018.

You can clearly see the difference in expense ratios of both variants. This will result  in a BIG difference in returns, in the future.

Also Read: Direct vs Regular Mutual Fund: 5 Reasons Why Direct Funds Will Make You Wealthier

3. Difference in Net Asset Value (NAV)

Due to the difference in expense ratio, the resulting NAV of the same fund’s direct plan will be much higher.

And the gap between the NAV of a regular and direct plan will only increase with time.

Let’s have a look at the regular and direct NAVs of the same mutual funds mentioned in the previous table.

Fund Name NAV – Regular Plan (INR) NAV – Direct Plan (INR)
HDFC Small Cap Fund 45.49 48.3
SBI Bluechip Fund 38.76 40.83
L&T Short Term Income Fund 19.13 19.47
Indiabulls Liquid Fund 1746.28 1755.98

*the above NAV is as observed on 18th September 2018.

You can clearly see the NAV of the direct version of the same mutual fund is always higher. The older the fund, the higher the difference in NAV.

4. Difference in returns

Direct plan funds fetch you higher returns as compared to regular plan funds.

This difference can be substantial over long investment periods. The average difference in expense ratio between direct and regular plan is 0.66%.

While this number may not seem like a lot but this amount gets paid every year and with the power of compounding can balloon into a huge number over the years.

Let me show you a few examples

Here’s a comparison between the returns from direct and regular plans of 3 mutual funds.

For simplicity, I have taken an initial investment amount of ₹ 10,00,000 (lump sum) in all examples.

1. SBI Bluechip Fund

Direct Regular Difference
Initial investment amount ₹10,00,000 ₹10,00,000 0
Investment tenure 5 years 5 years 0
Avg. 5 Year Return 20.42% 19.27% 1.15%
Final return amount ₹25,23,771.53 ₹24,10,515 ₹1,13,256.53

As seen from the above table, there is a difference of ₹1,13,256.53 between returns from the direct and regular plan of this fund, with an initial investment amount of ₹10,00,000 for 5 years.

2. HDFC Small Cap Fund

Direct Regular Difference
Initial investment amount ₹10,00,000 ₹10,00,000 0
Investment tenure 5 years 5 years 0
Avg. 5 Year Return 27.11% 25.79 % 1.32%
Final return amount ₹33,18,169.71 ₹31,49,420.04 ₹1,68,749.67

As seen from the above table, there is a difference of ₹1,68,749.67 between returns from direct and regular plan of this fund,. The initial investment amount is taken as ₹10,00,000 for 5 years.

3. L&T Midcap Fund

  Direct Regular Difference
Initial investment amount ₹10,00,000 ₹10,00,000 0
Investment tenure 5 years 5 years 0
Avg. 5 Year Return  31.99% 30.92% 1.07%
Final return amount ₹40,05,946.5 ₹38,46,183.35 ₹1,59,763.15

As seen from the above table, there is a difference of ₹1,59,763.15 between returns from the direct and regular plan of this fund. The initial investment amount is taken as ₹10,00,000 for 5 years.

Also Read: Direct vs Regular Mutual Funds Examples: Returns of Top 10 Funds Compared

5. Professional advice

Professional financial advice is important and it can make a big difference to your returns. Mutual fund advisers can help you understand and manage your mutual funds more effectively.

However, it is not necessary that you depend on a mutual fund adviser. If you can do your own research and understand mutual funds well enough, you can invest in direct mutual funds thus avoiding the services of a mutual fund adviser.

You could also hire an independent mutual fund adviser to advise you also.

What is expense ratio?

A mutual fund is judged on various parameters, such as its past performance with respect to its benchmark, category average, asset allocation pattern, fund manager’s history etc.

Another common criterion that can help you select a suitable mutual fund is its expense ratio.

So, what exactly is an expense ratio?

Definition

The expense ratio measures the per unit cost of managing a mutual fund by Asset management companies (AMCs) . It is calculated by dividing the fund’s total expenses by its assets under management.

All the investment companies incur cost for operating mutual funds and they charge a percentage of asset funds to cover the expenses.

Impact of expense ratio

Let me explain its impact with a simple example.

Suppose you invest ₹1 lakh in a mutual fund, at an NAV of ₹10 and the expense ratio is 2%. After one year, there is a gain of 12% on the NAV.

So, ₹1 lakh has gone up to ₹1.12 lakhs.

However, after a deduction of 2%, the amount is reduced to ₹1.09 lakh, which translates into a loss of ₹2,240. Though it does not seem like a big reduction, it could impair the value of investments over the long-term.

Although a high expense ratio impacts the fund’s returns, it is not necessary that high expense ratio will always give low returns.

If the fund is managed in an aggressive manner, then high returns can be an outcome of high expense ratio due to the choice of investment and good stocks in the asset.

Various components of expense ratio

Major components of the expense ratio is legal, administration, advertising and management cost. This fee is different from  sales and commission or the expenses incurred on the buying and selling of portfolio.

There are 3 major types of expenses as a part of the Expense Ratio :

1. Management Fees

Mutual fund requires formulation of investment strategies, before actually investing money in the underlying assets.

AMCs employ highly qualified professionals to track developments in equity, debt and money markets and then transact accordingly in the asset market to attain the objectives that are stated in the fund’s offer documents.

For such specialized services, the AMC pays a management fee to the professionals. On an average, this fee is about 0.50% – 1.0% of the funds’ assets.

2. Administrative Costs

Administrative cost is the expense of running the fund. This would include:

  • Record keeping,
  • Custodial services,
  • Taxes,
  • Legal Costs
  • Accounting and Auditing Fees.

3. Distribution Fees (12B-1 fee)

The distribution fee is collected by most mutual funds for advertising and promoting the fund.

Most mutual funds charge their shareholders to market and promote the fund to investors.

Where to look?

If you are looking at a New Fund Offer (NFO), please go through the offer document section called ‘Fees and expense of the scheme’. This will give you the maximum expense ratio that a fund can incur.

For an existing scheme, you can look at monthly fact sheet or the Key Information Memorandum for the recurring scheme expense.

Why is there a difference in the expense ratio of a regular and direct plan?

Both versions are the exact same scheme, run by the same fund managers investing in the same stocks and bonds.

The difference is that in case of a regular plan, mutual funds pay a sales commission to the middleman or broker, who brings them business.

The amount of commission varies between 0.5% – 1.25% per year. Although this amount is not reflected in your monthly statement, the NAV of your mutual fund units get adjusted for this.

Whereas, in case of direct mutual funds, there is no broker or distributor commission. Which means, as an investor, you get higher returns from the exact same mutual fund.

SEBI has taken various measures to rationalize the expense ratio of mutual funds. In 2012, it made it mandatory for mutual funds to launch a ‘direct’ option in all their schemes.

Direct plans are meant for investors who deal directly with the fund house and do not use the service of a distributor.

As there are no commissions to be paid under this route, the expense ratio of direct plan is notably lower than those of regular plans.

However, the trend shows that investors are primarily investing in regular plans. The reason behind this can be:

  • They are unaware of direct plans,
  • They themselves cannot decide on fund selection,
  • They followed easily accessible online channels, which majorly promote Regular plans, and
  • They are unaware of the fact that they can shift from regular to direct plans.

Conclusion

It is established that the expense ratio is a deciding factor in the kind of returns you earn on mutual funds.

It is advisable to opt for a direct mutual fund, as the returns offered by the direct plan of a mutual fund will always be higher than the regular plan of the same fund, as seen from the above comparison of both variants of mutual funds.

Due to this, the expense ratio of direct plans will always be lower, when compared to regular plans.

Investors would get higher returns compared to regular plans. The returns would be higher by around 1% per annum for a 5 year investment tenure, as seen from the above comparison of 3 mutual funds.

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww