Direct plans of mutual funds are meant only for savvy investors
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Direct plans of MFs are only for savvy investors

Direct plans have a lower expense ratio since they do not engage distributors, hence saving on distribution expenses and commissions paid to the distributors.

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Illustration: Raj Verma

Direct plans of mutual funds (MFs) have lately gained a lot of popularity, and with reason. If an investor does not need investment advice from an intermediary, he can boost his MF returns by up to one per cent on an equity fund and 0.50 per cent on long-term income funds. This difference in returns doesn't sound much when the markets are hitting new highs and diversified equity MFs have returned 20 per cent on average in the year (till May 25). But since this is an annual charge, even a one percent difference could mean substantial savings owing to the power of compounding.

Let us say you invested Rs 10 lakh in a fund with a total expense ratio (TER) of 2.5 per cent. (The TER is a charge that a fund levies on your investment to manage your money. A higher TER will result in lower returns and vice versa.) If the fund earns 15 per cent and its TER is 2.5 per cent, it would mean a net return of 12.5 per cent. In this case, Rs 10 lakh invested for 10 years at 12.5 per cent CAGR would grow to Rs 32.50 lakh. A one per cent lower charge would mean this amount would grow by 13.5 per cent, i.e., to Rs 35.50 lakh. The TER also matters in case of debt funds. The past year could be considered as a bumper one for debt funds as they posted double-digit returns. In the long run, these funds, typically, record high single-digit returns. Hence, in a low-yielding environment, any additional expense levied on these funds will count, making it a differentiating factor amongst funds.

Market regulator SEBI (Securities and Exchange Board of India) has stipulated a limit on the TER. Equity funds, for instance, can charge a maximum of 2.5 per cent, while debt funds can charge 2.25 per cent of the average weekly net assets. Seemant Shukla, head of sales and business development at Edelweiss Asset Management, says the TER also depends on the assets under management (AUM) of the scheme. According to SEBI guidelines, the TER needs to fall as AUM increases. D.P. Singh, Executive Director and Chief Marketing Offi cer at SBI Mutual Fund, says a fund house managing assets worth Rs 2,000 crore would typically have a TER of 1.8 to 1.9 per cent (after operating expenditure), of which one to 1.40 per cent goes towards distribution cost and asset management companies (AMCs) are left with 0.40 to 0.50 per cent for AMC management fees.

How do funds manage to give you additional returns? Direct plans have a lower expense ratio since they do not engage distributors, hence saving on distribution expenses and commissions paid to the distributors. These plans have a separate net asset value (NAV) that refl ects the lower charge. Take, for instance, the ICICI Prudential Focused Bluechip Fund. The year-to-date expense ratio for its direct plan is at 1.30 per cent, much lower than the 2.16 per cent for its regular plan. Owing to the reduced costs, the returns from these funds increase by a similar extent. This is a trend seen across fund houses (see Higher Returns).

Direct plans have been in existence since 2013, in accordance with a SEBI ruling. This allowed AMCs to create direct plans not routed through a distributor in existing as well as new schemes. While investing in direct plans, the investors deal with the AMC directly, either through offl ine or online channels, and no intermediary is involved.

Are direct plans suitable foryou? "Direct plans are only suited to fi nancially aware investors or if one wants to invest into plain vanilla products," says Singh of SBI MF. According to a CRISIL report, the share of vanilla products like liquid funds was highest in direct plans, followed by ultra short-term funds, the categories which see higher investment by institutional investors. The report says more institutional investors and wealthy individuals are likely to shift to direct plans as these investors are more capable of taking informed decisions.Further, do not choose a fund only because it has a lower TER; it may not necessarily be better. It will not make sense if you save one per cent on charges and invest in a fund that underperforms its category by fi ve per cent. For retail investors, it may be best to invest in MFs based on a financial plan created in accordance with their investment objective.

RISING COSTS

In September 2012, SEBI allowed AMCs to charge up to 0.30 per cent more on the expense ratio if a specifi ed proportion of new infl ows into a scheme came from locations beyond the top 15 cities. This was to help increase the reach of MFs among the masses. "While it is important for the MF industry to improve its geographical reach and bring in long-term retail money from smaller towns, like any other businesses, it should have been the AMC who bears their expansion cost rather than the investor paying additional TER," says Jimmy Patel, CEO, Quantum Asset Management.

SEBI also mandated AMCs to plough exit loads back into the scheme. But to compensate this loss in revenue from exit load collections, AMCs were allowed to levy a TER of 20 basis points. So in all, an additional 50 basis points were allowed to be charged in addition to the 2.5 per cent expense ratio. Hence, a small fund, which has an AUM below Rs 100 crore, could end up charging three per cent. The new rules also allowed service tax on the investment management fee to be charged to the scheme, which means it would be borne by investors. According to Patel of Quantum, there has always been a lack of transparency in the transaction, distribution and market cost in the MF industry.

"The commission paid is typically not disclosed, which compromises the interest of the investor," he adds. To address this issue, SEBI has mandated distributors to disclose the commission they earn on the scheme they recommend to investors compared to its peers. On average, the annualised fees for distributors are in the range of 0.50 to one per cent for equity funds. While some AMCs may give upfront commission, the rest offer a trail commission. In short, as an investor you must be aware of the commission a distributor would earn from the scheme recommended to you and decipher whether it is in your interest.