📊What are Direct and Regular Mutual Funds?

Direct plans of mutual funds have no commission, lower fees compared to its Regular plan counterpart. Returns are higher with no extra risk.

A mutual fund is not free from costs. An asset management company (AMC) is a for-profit entity who aim to make some profit from their venture. They also have to pay their security analysts, operations teams, pay brokerage fees for market participation, and record keeping fees to registrars like CAMS and KFintech, formerly known as Karvy.

A regular plan of a mutual fund has one more additional expense — distributor commission.

Why is distribution commission bad for an investor?

There are many reasons why regular plans shouldn’t exist.

• Erosion of Value

  Regular Plans add no value to the portfolio of an investor. All it does is eats away at your portfolio valuation and make the distributor richer.

  This cost scales with your portfolio valuation. The more your investments grow in value, the more money is taken out of your investment.

  It’s a classic case of tyranny of compounding costs, words made famous by Jack Bogle.

• Distributors are Inherently Biased Against the Investor

  The distributor which subscribes an investor to a regular plan is inherently biased against an investor because the distributor would recommend funds which have high distributor commissions regardless of whether the fund is actually good for an investor or not.

To prove our point, here’s an example.

As of February 2021, Mirae Asset Tax Saver had a total expense ratio (TER) of 1.83% for its regular plan and 0.28% for its direct plan. That’s a difference of 1.55% between the regular plan and the direct plan of the same fund. On the other hand, UTI Nifty Index had a total TER of 0.14% for its regular plan and 0.1% for its direct plan.

The assets under management (AUM) distribution of these two funds is interesting. Mirae Asset Tax Saver had AUM of ₹6,332.2 crores out of which 31% AUM is from the direct plan and the rest is from its regular plan. Meanwhile, UTI Nifty Index had a total AUM of ₹3,353.11 crores but had 77% of its AUM from its direct plan.

This stark difference in the source of AUM should be enough to highlight where the priorities of regular plan distributors lie.

• It’s unfair

  You might’ve placed a purchase order five years ago in the regular plan of a fund, to purchase some units. This one transaction and subsequent payments, have been lining up pockets of the distributor, every day, for the last five years. And it would continue to do so as long as you have even a single unit in the regular plan of the fund.

• Meanwhile, the distributor is not at all involved in the process of managing your portfolio — that’s being handled by the respective AMC.This payment model of perpetual payment in eternity is rarely ever seen in nature, outside of this one use-case. Imagine visiting a doctor who demands 1% of your income every month in perpetuity till you’re alive.

• It’s sneaky

  For most mutual fund investors out there, the disadvantages of investing in regular plans are not well understood. Lack of financial knowledge, and fear of complexity have driven a generation of investors to blindly trust their distributors without looking too closely at account statements.

  But this charge is so sneaky, there’s no column in most account statements sent by AMCs, that include an entry for the amount that went to your distributor in the last 1M / 1Y / 5Y.

• Fortunately, your NSDL / CDSL consolidated account statement (CAS) would include this information.If distributors have faith in their financial advice and planning, they should have no shame in openly sharing with their clients, how much they’ve made blindsiding them. Or, the distributors should send an invoice to said clients. But they don’t, and to hide this daylight robbery, the payment is done by an AMC to the distributor directly, at periodic intervals.

What difference does an extra 1% make?

Let’s try to understand, with real world scenarios, exactly how much one can stand to lose investing in regular plans. However, before we get there, let’s discuss what direct plans are.

The only difference between a direct plan and a regular plan of a mutual fund is that direct plans do not have distributor commissions. The word direct must be present in your NSDL / CDSL / AMC account statements if you’re investing in a direct plan of a mutual fund.

Although it may not be straightforward to calculate the difference in returns between a regular plan and a direct plan of a mutual fund from AMC account statements, we can calculate it by simulating the same transactions on the same date in the direct plan of a fund.

Lumpsum Purchase in Axis Long Term Equity and Tata Large Cap

As of 9th April 2021, the 5 year return (CAGR) of Axis Long Term Equity Direct Growth Plan stands at 17.70% and that of the regular plan is 16.55% Let’s assume an initial investment of ₹1 lakh on 9th April 2016.

Fund Type	5Y CAGR	Final Value
Direct Growth	17.70%	₹1,00,000×(1+0.1770)5=₹2,25,882.36₹
Regular Growth	16.55%	₹1,00,000×(1+0.1655)5=₹2,15,060.86
	Commission Outflow	₹10,821.5

The distributor of this plan has made approximately 10.8% of the original investment as commission in the last 5 years. And 5 years is a small time period in equity markets. Of course, this commission will only increase with time. However, this cost could’ve been easily avoided, just by investing in the direct plan of the same fund, 5 years ago.

One might say that the commission looks high only because the returns are high enough to more than double the original investment. After all, 16%−17% annualized returns over 5 year periods aren’t common.

Keeping this in mind, let’s take a different fund with a lower 5Y CAGR, where we do the same comparison, and see if losses to commission really goes down with the returns. As of 9th April 2021, the 5 year return (CAGR) of Tata Large Cap Direct Growth Plan stands at 13.82% and that of the regular plan is 12.40%

Fund Type	5Y CAGR	Final Value
Direct Growth	13.82%	₹1,00,000×(1+0.1382)5=₹1,91,026.19
Regular Growth	12.40%	₹1,00,000×(1+0.1240)5=₹1,79,403.77
	Commission Outflow	₹11,622.42

Although the returns and nominal profit of the investor have been reduced by a lot, the distributor commission has increased! In this case, it’s approximately 11.6% of original investment, eroded over 5 years. Your distributor would make bank, whether your returns are higher or lower. They’d make even more, if your portfolio does well.

Next time, when a distributor tells you to keep your SIPs going, you have to wonder whether it’s because they don’t want to see their income disrupted, which is tied to total portfolio value.

Total Expense Ratio from an AMC’s Perspective

Let’s consider Kotak Standard Flexi Cap, one of the largest (in terms of AUM) equity mutual fund in India with an average AUM of ₹35,114.711 crore at the end of March 2021. Its direct plan had a TER of 0.61% and the regular plan had a TER of 1.62%.

From the average AUM disclosure provided by Kotak AMC for the month of March 2021, we know that Kotak Standard Flexi Cap had ₹25,899.100 crores from its regular plan and ₹9,215.61crores from its direct plan.

We can use this data to get some insights about the expenses generated by this fund.

Fund Type	AAUM	Expenses Deducted
Direct Plan	₹9,215.61	₹35,114.71×0.61%=₹214.19₹35,
Regular Plan	₹25,899.10	₹25,899.10×(1.62%−0.61%)=₹261.58crores
	₹35,114.71 crores	Total Expenses: ₹475.77₹475.77 crores

Kotak AMC gets to keep ₹35,114.71×0.61%=₹214.19 crores from both the regular and direct plan. Since distributors get 1.62%−0.61%=1.01%on the regular plan, their commission comes out to be ₹25,899.10×1.01%=₹261.58 crores.

In a mutual fund with over ₹35,114 crores in AUM, 73% of its AUM comes from regular plans and mutual fund distributors end up taking away 22% more expense income than the AMC of the fund itself even though the fund manager does the job of managing the mutual fund portfolio while your distributor does nothing except earn commissions and help the AMC inflate its AUM.

In mutual funds, TER is an yearly average expense deduction. It’s deducted everyday before publishing the new NAV of the fund. All returns reported on mutual funds, are after costs have been deducted. There’s no need to subtract TER from final returns or NAV, as it’s been already factored in.

SIP for 8+ Years

As on 9th April 2021, the direct plan of mutual funds have had more than 8 years of history since they were started back in January 2013.

We’ll simulate a SIP of ₹10,000 per month, in the direct and regular plan of some funds, starting from 2nd January 2013.

We are considering some large-cap funds that have mostly stayed true to their large-cap stock selection mandate, i.e., mostly having bluechip stocks in portfolio of the fund. Mirae Asset Large Cap fund has been excluded, as it was operated as a multi-cap fund throughout most of this time period (2013-2018) that’s being considered.

UTI Nifty Index

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹17,71,612	₹7,71,612	13.5%
Regular Plan	₹10,00,000	₹17,64,606	₹7,64,606	13.4%

HDFC Top 100

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹16,94,408	₹6,94,408	12.5%
Regular Plan	₹10,00,000	₹16,42,630	₹6,42,630	11.8%

Franklin Bluechip

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹17,33,671	₹7,33,671	13.0%
Regular Plan	₹10,00,000	₹16,68,038	₹6,68,038	12.1%

ABSL Frontline Equity

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹17,86,176	₹7,86,176	13.7%
Regular Plan	₹10,00,000	₹17,14,436	₹7,14,436	12.8%

SBI Bluechip

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹19,05,761	₹9,05,761	15.2%
Regular Plan	₹10,00,000	₹18,23,117	₹8,23,117	14.2%

DSP Top 100

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹16,40,187	₹6,40,187	11.7%
Regular Plan	₹10,00,000	₹15,87,479	₹5,87,479	11.0%

ICICI Prudential Bluechip

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹18,34,300	₹8,34,300	14.3%
Regular Plan	₹10,00,000	₹17,63,591	₹7,63,591	13.4%

Nippon Large Cap

Fund Type	Invested Amount	Current Value	Total Gain	Return (p.a.)
Direct Plan	₹10,00,000	₹17,83,845	₹7,83,845	13.7%
Regular Plan	₹10,00,000	₹17,05,182₹17,05,182	₹7,05,182	12.6%

As we can see, in the large cap space, equity mutual funds have mostly performed in-line with the index funds over the last 8 years. Most of them have underperfomed, but some of them have outperformed.

Let’s look at the data presented above from a different perspective. We’ll focus on distributor commissions and their impact on our portfolio.

Fund Name	TER (Regular)	TER (Direct)	ΔΔ TER	Commission Losses	Commission (% of total investment)
UTI Nifty Index	0.14%	0.10%	0.04%	₹7,006	0.07%
HDFC Top 100	1.85%	1.23%	0.62%	₹51,778	5.17%
Franklin Bluechip	1.91%	1.18%	0.73%	₹65,633	6.56%
ABSL Frontline	1.70%	1.08%	0.62%	₹71,740	7.17%
SBI Bluechip	1.75%	1.00%	0.75%	₹82,644	8.26%
DSP Top 100	2.09%	1.32%	0.77%	₹52.708	5.27%
ICICI Pru Bluechip	1.72%	1.21%	0.51%	₹70,709	7.07%
Nippon Large Cap	1.88%	1.18%	0.70%	₹78,663	7.86%

In the above tables, we’re using the TER data available as on 9th April 2021. TER changes from time to time, and the latest TER differences won’t reveal historical performance.

Besides SBI Bluechip’s regular plan, no large-cap fund from our list has managed to generate higher corpus in its regular plan than UTI Nifty Index fund direct growth plan has done over the last 8+ years for a simple ₹10𝑘/ month SIP.

As you can imagine, no popular distributor was publicly recommending UTI Nifty Index fund’s direct plan, back in 2013-14. This isn’t surprising considering the fact that for a regular plan distributor, recommending UTI Nifty Index fund’s regular plan would’ve been the least profitable.

How Bad Will It Be in the Long Run?

Unfortunately, investing in the regular plan of a mutual fund is only the beginning. As more and more time passes by, staying invested in the regular plan of a fund will erode your portfolio further.

As Jack Bogle said:

The miracle of compounding returns has been overwhelmed by the tyranny of compounding costs.

The recurring cost model of regular plans can unleash this mythical tyranny right on your portfolio, without you even realizing it.

We saw earlier that the difference in TER difference between the direct and regular plan of a mutual fund, or TER, can be thought of as an indicator of regular plan’s distribution costs.

Let’s assume that investing a lumpsum amount of ₹1,00,000 in an asset generates a CAGR of 15%. This asset also has a regular plan variant which generates a CAGR of 14%. At 1% lower CAGR, this is how the valuation would change over time.

Regular Plan Returns Trailing by 1%

If the difference in CAGR is assumed to be 1.5%, this is how the corpus changes.

Eventually, an investor could end up losing 30%−40% of their portfolio to distributor commissions over a long period of time.