Direct mutual funds promise a low expense ratio. For an investor, lower cost means higher returns. Then, what happens to regular funds? More importantly, why is the expense ratio different in Direct MFs and Regular MFs?

What Is Expense Ratio?

To comprehend the question, you must first pursue the term- Expense Ratio. The cost for an investment company to manage a mutual fund is measured in “Expense Ratio”.

Arrived at by an annual calculation, the expense ratio is equal to the fund’s operating expenses divided by the average value of fund assets. Operating expenses include:

  • Fees for fund’s investment manager,
  • Record keeping,
  • Custodial services,
  • Taxes,
  • Accounting and Auditing Fees, and
  • Marketing cost (applicable in selected MFs), also termed as 12B-1 Fee.

In short, it is the percentage of fund assets used for the company’s administrative, advertising, and management.

This amount is paid by or is deducted from the investors. There are certain upper limits which fund houses need to follow while ascertaining charges or fees and can be broadly classified as:

  • Maximum annual charges: 2.5% (if their fund size is < Rs.100Crs; 1.85% if fund size has an “Asset Under management” (AUM) of approximately Rs.1000Crs.)
  • GST: 18%
  • Additional B15 incentive (Allowed by SEBI fund houses can charge additional 30BPS [Basis points] if inflows from B15 cities are at least 30% of the gross new inflows)

The various components can be understood with an example of the HDFC Equity fund (a regular plan):

Expense Head HDFC Equity Fund
Investment Management Fees 1.25%
Trustee Fees 0.10%
Audit Fees 0.01%
Custodian Fees 0.01%
Registrar & Transfer Agent Fees 0.15%
Marketing and selling Expenses including Agents Commission and statutory Advertisement and Brokerage & Transaction Cost pertaining to the distribution of units 0.75%
Investor communication cost and fund transfer cost 0.15%
Other expenses 0.08%
Total expenses 2.5%

Hence, the expense ratio is a major factor in deciding the returns for an investor. 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.

What Is Basis Point?

In 2012, SEBI brought amendments in regulations which changed the mutual funds market. To understand one such change, which affected the expense ratio to be charged, you must understand the term – Basis Point (bps).

Basis Point is equal to 1/100th of 1% and denotes the percentage change in financial instrument. The change done by SEBI affected the way fund houses were charging and investors were receiving returns.

Mutual Funds Then and Now

SEBI made the following critical amendments:

  • Higher Expense Ratio: To expand the reach of fund houses in rural areas, SEBI incentivized them with additional 30 basis points if new inflows from B15 cities (Beyond top 5 cities) are more than 30%. That signifies that apart from the 2.5%, now they can additionally charge 0.3%.
  • No internal limits on Expense Ratio: The ceiling of 1.25% for fund management and 0.5% for distribution cost was abolished and now mutual funds are allowed to decide on the distribution of expenses as they desire.
  • Birth of Direct Plans: There was no demarcation of the investments made by agents or investments done directly with Asset Management companies. This was implemented and Direct Mutual fund Plans were launched with a lower expense ratio. Therefore, if a mutual fund offers “A plan”, then it must offer another termed- A Direct Plan. The direct plan must have a lower expense ratio and was brought forward for those investors who have expertise in fund management and buy directly from AMCs without the help of agents or distributors.

To summarize:

Criteria Before Now
Expense Ratio Charged Max. 2.5% allowed Now additional 30 BPS is allowed if the fresh inflows from B15 towns are more than 30%
Internal Limits on Expense Ratio Internal Limits of 1.25% for fund management fees, 0.5% for distribution costs No limits now, mutual funds can decide on their own
Direct Scheme of MFs No distinction between an investment made by advisor or direct by investor A completely new category termed “Direct” has been introduced with a lower expense ratio

Regular Mutual Funds Vs Direct Mutual Funds

There are hardly any differences between regular and direct mutual funds, except for the fact that in the regular plan, the fund is managed by agents or fund advisors. While in the direct plan, fund management is done directly by the investor. Also, the expense ratio of regular plans is higher than the direct plans.

In short, the comparison chart will look like:

Regular Plan Direct Plan
You invest through mutual fund investment advisors or distributors, also termed as relationship managers. You take the responsibility of doing it yourself either by visiting the asset management company or by buying online on their website.
Investment recommendations or guidance are done by the investment advisor and you also get after sales service. You get no guidance, your own research will be your guide for investment.
Indirect Commissions are paid to investment advisors for their services by the AMC. The commissions are done by cutting the money you invest. No such commission as you do things yourself.
Higher expense Ratio Lower expense ratio

Why the Difference in Expense Ratio?

The difference in expense ratio makes regular plans higher than the direct plans. It is due to the fact that in regular plans, the agent commission, to the tune of 0.5% to 1.5%, is paid by the investor.

Direct plans do not have agents or advisors and, hence, these charges are not applicable. The difference in terms of expense ratio may seem miniscule-1%, but it can be substantial over a period of time.

How Will It Impact the Returns?

To understand the impact, let’s look at these examples.

Example 1:  Let’s assume you were to invest Rs.1,00,000 for 10 years. Assuming a return of 15%, the regular plan will yield Rs.4,04,555.7 and the direct plan will yield Rs.4,41, 143.51.

That means a difference of 1% in expense ratio will yield Rs.36,587.74 more in the direct plan.

Example 2: To better evaluate the quantum of 1%, let’s find out what happens when the amount is big, say Rs. 10 Lakhs.

If this amount is invested in the regular plan which grows at a rate of 8% annually, after thirty years (assuming your age is 35 years) the investment would be worth Rs. 76 Lakhs.

If the same has to happen in the direct plan, cutting 1% commission would have earned you Rs. 1 Crore.

To Conclude

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

Regular plans have higher expense ratio as they deduct investment advisor commission from your investment. Direct plans have a lower expense ratio and higher returns, but the risk of investment completely lays with your talent and dexterity in mutual funds management.

It can be easier to buy a regular plan than buying a direct plan yourself, but over a longer-term period, this will pay you a much higher dividend. A new or inexperienced investor is advised to go for the regular plan and a scholarly investor can always earn higher returns by investing in direct MFs.

As an investor, it’s you who needs to make the choice and remember two rules:

  • Never lose money.
  • Never forget rule 1!

Happy investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.