Why should I prefer Direct plans over Regular plans?

--- tags: FAQs title: Why should I prefer Direct plans over Regular plans? description: Direct plans of mutual funds have no commission, lower fees compared to its Regular plan counterpart. Returns are higher with no extra risk. --- # What is a Regular plan? A mutual fund is not free from cost. Here are a few of the costs because the fund house: - is a for-profit entity. They'd have to make some revenue from this venture. - has to pay its security analysts and operations teams' salaries and other employee benefits; in addition to bear operational expenses (maintaining an office, for example). - would've to pay brokerage and other fees in the markets, to manage the underlying portfolio of the fund. - has to pay record keeping fees to the registrars, to maintain detail records of transactions; and bear various compliance costs A mutual fund has various expenses, only a handful of these have been noted above. Regular plans are an offering of a fund by AMC (**A**sset **M**anagent **C**ompany), where in addition to these expenses of running a fund, an additional expense is added: **distributor commission**. This is an incentive to the distributors, who get their clients to sign up for these funds. In summary, a regular plan of a mutual fund deducts a portion of your investments in that fund, to pay the distributor who sold you the fund. # Why is this bad? There are umpteen reasons why regular plans should not even exist: - Erosion of value It adds no value to end customer - the investor in the fund. Rather, it eats away at their portfolio valuation. It's a cost that _scales_ with your portfolio valuation. The more your investments grow in value, more and more money is taken out of that investments. Classic case of tyranny of compounding, working against you. - It biases the distributor who's sold you the fund. Given distributor commission is mostly to entice the distributors to sell the product, a specific fund from a fund house. Naturally, most distributor would want to sell you a fund, that pays them well first. The asset selection is then less about aligning with your financial goal, and more about which fund benefits your distributor more. - It's unfair. You might have placed a purchase order five years ago in regular plan of a fund, to purchase some units. This one transaction and subsequent payment, has been lining up pockets of the distributor, every day, for last five years. And it'd 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 fund management team. 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 0.01% of your income every month in perpetuity, till you're alive. - It's sneaky For most mutual fund investors out there, this reality is 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 _amount that went to your distributor in the last 1M / 1Y / 5Y_. If distributors have faith in their financial advice & 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 therefore to hide this daylight robbery, the payment is done by an AMC to the distributor directly, at periodic intervals. # How bad is it? Let's try to understand, with real world scenarios, exactly how much one can stand to lose investing in regular plans. Before we get there, we need to discuss **direct plans**. A direct plan of a mutual fund is one, where this distributor commission is not present, all other aspects (portfolio, fund manager, mandate, risk profile etc.) being exactly the same. In your account statement, direct plan of a mutual fund, must be listed with the word **direct** in its name. We'd mentioned earlier that it's not easy to derive from a single account statement, as there would be no specific column for how much commission would have been deducted. However, we can derive it from computing final portfolio value of an investment in direct plan; then comparing with same investments in regular plan of same fund. At the time of writing this, on 9th April 2021, the 5Y return (CAGR) of Axis Long Term Equity **Direct** Growth plan, stands at $17.70\%$ p.a. If someone had invested ₹100,000 (1L INR) 5 years ago, on 9th April, 2016; in this fund, it'd have become $100,000 \times (1 + 17.70/100)^5 = 225,882.36$ INR. On same date, if the transaction was done in Axis Long Term Equity **Regular** Growth, the _regular_ counterpart of this fund, which has a 5Y CAGR of $16.55\%$ p.a.; final valuation as on 9th April 2021, would have been $100,000 \times (1 + 16.55/100)^5 = 215,060.86$ INR. | Fund Type | 5Y CAGR | Final Value (INR) | | -------- | -------- | ---- | | Direct Growth | $17.70\%$ p.a. | $100,000 \times (1 + 0.1770)^5 = 225,882.36$ | | Regular Growth | $16.55\%$ p.a. | $100,000 \times (1 + 0.1655)^5 = 215,060.86$ | | | **Commission Outflow** | $10,821.5$ | The distributor of this plan, has made **~10.8% of original investment as commission in the last 5 years**. This deduction was not linear, it went up with time. but this cost could've been avoided, just by investing in direct plan of the same fund. One might say, _but 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 are really rare. So, let's take a different fund, where we do the same comparison, which has lower 5Y CAGR, and see if losses to commission really goes down with the returns. Following table is similar, but instead of Axis Long Term Equity, we use **Tata Large Cap** fund's direct and regular plans. | Fund Type | 5Y CAGR | Final Value (INR) | | -------- | -------- | -------- | ---- | | Direct Growth | $13.82\%$ p.a. | $100,000 \times (1 + 0.1382)^5 = 191,026.19$ | | Regular Growth | $12.40\%$ p.a. | $100,000 \times (1 + 0.1240)^5 = 179,403.77$ | | | **Commission Outflow** | $11,622.42$ | Returns and nominal profit of the investor has been reduced by a lot. However, the distributor commission has **only increased**! Now it's ~11.6% of original investment, eroded over 5 years. Your distributor would make bank, whether your returns are lower or higher. They'd make even more, if your portfolio does well. Next time, a distributor tells you to _keep your SIPs going_, ask them if it's because they don't want to see their income disrupted. # Falsehoods and Myths As you'd imagine, regular plans are a juicy proposition for every participant involved, except for the investor whose capital is being eroded. AMCs don't have a reason to compete on performance, when they can just offer more commissions on their funds; and the distributors would sing praises of said fund over other offerings. Distributors don't have to recommend good funds, because if it doesn't perform well, they could just tell you _markets were bad this year, keep your SIPs going and buy at lower prices_ - because it directly benefits them. To understand how deep this nexus is, take a look at AMFI disclosure reports on commission to distributors, from past years: [Link to commission disclosure](https://www.amfiindia.com/commission-disclosure) | [archive.org link](https://web.archive.org/web/20201111223806/https://www.amfiindia.com/commission-disclosure) | [archive.is link](https://archive.is/W7Pzy) Let's start with the latest repor, from 2019-20. It's a PDF that list name of the distributor and gross amount paid in multiples of ₹100,000 (Lacs). If you notice, big banks like HDFC / ICICI / Kotak / SBI / Kotak are easily making **few hundred crores** (1 crore = 100 Lacs = 10 millions) in INR, just from _rent-seeking_ and not adding any meaningful value to portfolio of investors. And relatively smaller distributors have been doing well as well. Based on that list, it's not that uncommon to make over 1 Cr. (a pretty large milestone in annual income for most Indians) INR selling regular plans of mutual funds. Clearly, with such massive financial incentive, the regular plan industry would create falsehoods and myths, to mislead unsuspecting investors. This section covers a few of those, and how we address those. 1. **Direct plan NAV is always higher. Buy low, not high.** Your purhcase price is immaterial. What matters, is the rate of growth _after_ you purchase. Imagine, if price of a security is $X$, at the time of purchase. You invested capital $C$ in it. Then number of units purchased, is $\frac{C}{X}$. If the security now growth by $r%$, over a period of unit time $n$, then final price is $X(1 + r)^n$, portfolio and value is : $(\frac{C}{X})\times X(1 + r)^n$ Which can be written as $C(1 + r)^n$. This doesn't depend on $X$, original purchase price. Direct plan of a fund would always outperform regular plan of same fund, over any given period of time. Therefore, $r$ in direct plan would be always higher. 2. **Small 0.7%-0.8% expenses is not important** A fund has a TER (**T**otal **E**xpense **R**atio), that indicates expenses deducted from the fund's AUM (**A**sset **U**nder **M**anagement). Consider the example of Axis Long Term Equity. At the time of writing this, TER for Direct plan is $0.72\%$, while TER for regular plan is $1.61\%$. As expected, regular plan of the fund has higher expense ratio. The difference in these two TERs, is approximately indicative of how much the distributor has been pocketing as expenses. In this case, the difference comes out to be $1.61\% - 0.72\% = 0.89\%$. It looks small. It's not even $1\%$!. And yet, this less than $1\%$ commission which looked almost innocuous, has erored more than $10\%$ of the original investment. And not $5 \times 0.89\% = 4.45\%$ Keep in mind these are recurring expenses, compounded cost working against you. In absolute terms, as times pass by, these commission losses would be going higher and higher, growing exponentially. 3. **I know regular plans are bad but if I switch, there'd be taxes. I want to save on taxes.** Taxes are on realized gains. Commission is on entire corpus. Just like the largest ant is no match for the smallest elephant, your taxes might be low enough, if any, compared to your potential commission losses over next few years. Even if it's not, tax is a one-time headache. Commissions are forever, till the date you've zero units to your name in that regular plan of a fund. You could also switch out partially, and not all at once. That'd save you some taxes by spreading your redemptions over more than one financial year. In a scenario like this, it's best to compute the potential values for tax liabilities, and project losses in commissions; and make a choice, on a case-by-case basis. 4. **We also give advice. Direct plan is for advanced investors only** Recommending direct plan is a risk-free way of improving returns. A good advisor recommends direct plan to their clients. When you invest in a mutual fund, the fund manager is your advisor. They keep the portfolio up to date according to market conditions. Your distributor has no role to play there. We'd discussed earlier how regular plan can misincentivize financial planners, to recommend funds that have highest difference between TERs of regular plan and that of direct plan. We've so many direct plan platforms today, that offer free direct-plans to every investor in the country, that it's much easier to invest in direct plan & manage your portfolio these days, than it is to invest in regular plan. In 2018, market regularor SEBI published a notice, basically saying _distributors cannot be advisors_. # Wrapping Up In India, Quantum AMC launched their two flagship funds, Quantum Liquid fund and Quantum Long Term Equity fund as the original direct plans, back in 2006. They chose to not tie up with distributors, rather offer a direct purchase option to the investors via offline mode (CAMS or KFinTech offices) or their own website. Since 2013 January, according to SEBI regulations on direct plans, all funds from all AMCs have had to launch a direct plan variant. Despite ease of access and transaction, retail and HNI (**H**ight **N**et-worth **I**ndividual) investors still invest in regular plans. Most of the mutual fund industry AUM is in regular plan, and not direct plan. [According to this news article from The Hindu](https://www.thehindu.com/business/Industry/direct-plan-vs-regular-plan-know-which-one-is-better/article32121374.ece) ([archive.org link](https://web.archive.org/web/20210208172051/https://www.thehindu.com/business/Industry/direct-plan-vs-regular-plan-know-which-one-is-better/article32121374.ece) | [archive.is link](https://archive.is/c2oxb)), only **19%** of industry AUM is in direct plans, while rest of it are in regular plans. Regular plan distributors recommend funds that net them a decent commission, close to 1% of higher. And if they recommend more than one fund for a typical portfolio, usually, the one with higher commission would get higher allocation. [PayTM Money maintains this page, listing difference in TERs between direct plan and regular plan of mutual funds, in a table](https://www.paytmmoney.com/mutual-funds/direct-vs-regular-plans). If you haven't yet, take a look at your portfolio, and see if the word "direct" appears anywhere. Cross-check your account statements, for name of the funds you hold. You might be losing money to a rent-seeker without receiving anything of value in return. If that's the case, start the process of switching to direct plan today.