The mutual funds industry witnessed the most remarkable reform in its history 10 years ago with the launch of direct plans, which did away with commissions or fees paid to the distributors and, thereby, lowered the overall expenses for the investors.
In short, the cost to the investor reduced, giving a leg-up to the returns from the same funds. Our numbers show that investors make more in direct funds, but the number of folios in direct plans is still much lower than regular distributed schemes.
As direct plans celebrate their 10th anniversary, we look back at how direct plans came into being and try to make sense of the investor behaviour in terms of their lower uptake despite higher returns.
The Birth Of Direct Plans
Capital markets regulator Securities and Exchange Board of India (Sebi) first introduced direct plans through a circular dated September 13, 2012, asking fund houses to introduce separate options for direct investments.
But, in order to understand how this circular came into being, we will have to step back in time.
The Entry Load Era: Until 2007, fund houses charged an entry load or fees of 2-2.5 per cent for investing in equity schemes, either through the distributors or directly with the fund house.
Despite that, thanks to the upbeat market conditions, there was growing interest in the stock market. To give a further push to retail participation in the stock market, then Sebi boss M. Damodaran came up with the idea of incentivising investors for investing directly with the fund house. On December 31, 2007, Sebi in a letter to the Association of Mutual Funds (Amfi) asked them not to charge entry load to those investing directly with the fund house.
“At present irrespective of the mode of entry, investors are required to pay the entry load. Keeping in view the interest of the investors it has now been decided that no entry load shall be charged for direct applications received by the Asset Management Company (AMC) i.e. applications received through internet, submitted to AMC or collection centre/Investor Service Centre that are not routed through any distributor/agent/broker,” read the letter.
Ban On Entry Loads: While Damodaran set the stage to incentivise investors for direct investment, it was C.B. Bhave, the next Sebi boss who took over after Damodaran on February 19, 2008, who took the idea of getting rid of entry loads forward.
The year 2008 was a tough time for the stock market as the market downturn drove investors away. In 2009, in what seemed a bid to attract investors, Sebi abolished entry loads.
After the abolition, fund houses started to incentivise distributors by paying them a part of the total expense ratio (TER), which fund houses charge for managing investors’ money. Now, all investors—distributor-led or direct—were charged the same expense ratio. In effect, this meant there was no additional incentive for direct investors.
The Final Step: Since the ban on entry loads did not translate into any additional benefit for direct mutual fund investors, the succeeding regulator, U.K. Sinha, came up with something new to incentivise direct investors. The mutal fund industry veteran, who had served India’s oldest fund house UTI Mutual Fund as chairman earlier, came up with direct plans, which did away with distributor commissions from TER. In effect, this reduced the TER for direct investors.
Advantage Direct Plans
The idea behind the introduction of direct plans was to reduce the cost for investors who invest directly with the fund house and do not use the service of a mutual fund distributor or advisor. In simple terms, it’s like driving a car on your own rather than hiring a driver, who will come at an additional cost.
Typically, TER includes fund management charge, marketing expenses, registrar fee, custodian fee, and others. In regular plans, TER tends to be higher because the fund houses pay a commission to distributors for their services.
The higher the cost, the lower will be your returns. Let’s understand through an example. Say, an investor puts in Rs 10,000 each in two schemes, A and B, both of which return 15 per cent annually. If scheme A’s TER is 1 per cent and scheme B’s 2.5 per cent, over 10 years, the maturity value for scheme A will be Rs 36,587 and Rs 31,407 for scheme B.
For more clarity, we examined the actual returns of direct plans versus those of regular plans. We chose equity funds to show the difference because the equity funds category has the highest retail participation. According to data from the Association of Mutual Funds In India (Amfi), as of September 2022, among major categories, retail participation was the highest in equity schemes at 53.46 per cent. However, among all categories, the highest retail participation was seen in solution-oriented funds, at 70.25 per cent, despite the fact that the assets under management in this category is very low compared to the equity category.
We ran the data for systematic investment plans (SIPs), a popular mode of investments. We took an SIP amount of Rs 5,000 in both regular and direct plans of some of the best performing and highly popular schemes. As expected, the return from direct plans was higher.
For instance, Mirae Asset Large Cap Fund gave the highest internal rate of return (XIRR) in the large-cap category—of 16.73 per cent and 15.60 per cent in direct and regular plans, respectively. Interestingly, in the last 10 years, the SIP investment of Rs 6 lakh in this fund grew to Rs 14.26 lakh and Rs 13.42 lakh in direct and regular plans of Mirae Asset Large Cap, respectively. The difference in the corpus is Rs 82,945.
Similarly, for SBI Bluechip Fund and ICICI Bluechip Fund, the direct versions earned more—Rs 67,540 and Rs 60,788, respectively—than the regular ones.
Why Are Individuals Staying Away?
Despite the obvious difference in the returns between direct and regular plans of the same scheme, only about 25 per cent individuals appear to see the benefit. According to data from Amfi, out of 13.89 crore individual mutual fund investment folios, merely 3.45 crore folios are in direct plans, as on November 30, 2022. The number is bleaker if you look at it from the lens of assets under management (AUM). Of over Rs 40 trillion of MFs’ AUM, just 11.93 per cent comes from the direct individual category.
How does one understand this? Anthony Heredia, managing director and CEO, Mahindra Manulife Mutual Fund, says, “I see two key reasons. One, funds have created value even with regular plans over longer time frames. Two, and more importantly, you need reach and awareness to get the message across and that comes at a cost.”
While the message may not be going across to individual investors, institutional investors are clearly moving towards direct plans. A little more than 50 per cent of non-individual investors are into direct plans—out of 8.38 lakh folios, 4.42 lakh are in direct plans, according to Amfi data.
“Institutional investors invest more in direct plans because they have dedicated resources to take investment decisions, which a retail investor may not have,” says a Mumbai-based MF distributor, who did not want to be named.
What Should You Do?
To be able to invest in a direct plan, you would need to choose it either through individual research or with the help of a financial advisor. Finding a suitable fund may require research, considering that the mutual fund universe is large and not all funds in the same category may be the best choices.
Those who are unable to decide for themselves often find it easier to approach a distributor rather than a Sebi-registered investment advisor (RIAs) who may guide them to a direct plan. There are primarily two reasons for that—lack of adequate number of advisors and also an investor’s unwillingness to pay an upfront fee to the advisors.
Sebi came up with investment advisor regulations in 2013, wherein it allowed RIAs to charge a fee from investors for their advice. But the number of RIAs is minuscule compared to the mutual fund industry’s AUM size. As per Sebi data, there are only 1,328 Sebi RIAs. Out of this, less than 1,000 are active, says Suresh Sadagopan, founder of Ladder7 Financial Advisories, a Sebi-registered investment firm. “Also, very few people are willing to pay for investment advice. Most direct investors take investment advice either from friends or relatives,” adds Sadagopan.
While you may want to compare the fees charged by advisors with the commissions you pay for regular plans, remember that financial advisors can give you more holistic advice, rather than just for a fund. Ultimately, you need to decide whether you want to drive through the rough investing terrain on your own or hire a driver. Choose carefully.
kundan@outlookindia.com