As more and more investors shift their investment money from traditional options such as FDs into mutual funds, the considerations regarding high expense ratio are growing more prominent. With the view that a lower expense ratio is a better option for ensuring potentially higher returns some investors have started showing interest in direct plans of mutual fund schemes. Direct plans are in fact not a separate scheme but a variant of existing schemes that cut out the commission payable to a middle man such as a broker and this provides investors with a lower expense ratio. Direct plans are a relatively recent introduction in India’s mutual fund industry with the first ones being announced in January 2013 and at present, direct plans of funds across all AMCs (Asset Management Company) in India account for a very small portion of the industry.
Difference Between Direct Plans vs. Regular Plans
Prior to January 2013, the only option that Indian mutual fund investor had was to go for a regular plan (also known as a retail plan). The regular plan was and is still available through multiple routes including – brokers, broking houses, various securities market intermediaries, RTAs such as Cams and Karvy as well as the fund houses and their local representative offices. When availed through brokers, brokerage houses and other third-party intermediaries, the investor is required to provide a unique identification number called the ARN or Acquirer Reference Number. The ARN provides the fund house with the information on who should receive the commission for the sale of units in question. This “cost of acquisition” is subsequently passed on to the investors as part of the mutual fund scheme’s expense ratio.
In case of direct plans, the routes available to the investor are limited – the fund house itself, select authorized local representatives of the fund house and RTAs such as CAMS/Karvy. Very few third-party securities intermediaries currently offer direct plans hence relatively few investors actively seek to invest in mutual funds through the direct route. In case of most direct plan investments, no ARN is quoted in the investor’s application, hence the commission paid to investors is lower or nil which decreases the cost of customer acquisition for the fund house. This benefit of lower or zero commission is passed on to the scheme’s investor in the form of a lower expense ratio as compared to the regular plan of the same scheme.
Benefits of Direct Plans
Direct plans are not counted as separate schemes altogether, but they are in fact considered to be variants of the principal scheme launched by the funds. The following are some of the key features of direct plans that an investor should consider before making their direct mutual fund investments:
Lower Expense Ratio: This has been the de-facto selling point of direct plans across India. As explained earlier, this lower expense ratio is mainly due to the fact that direct funds do not feature broker commissions unlike regular plans of mutual funds. The lower expense ratio provides potentially higher returns to investors who opt for direct plan investments. However, this lower expense ratio is more beneficial for investors opting for lower return instruments such as liquid funds rather than equity funds which have historically provided investors with relatively higher returns.
Higher NAV vs. Regular Plan: The direct plan of the scheme usually features a higher NAV as compared to the corresponding regular plan NAV. This is because the lower expense ratio leads to fewer payouts from the fund, which increases the overall AUM of the scheme vs. the number of outstanding units of the scheme. Because NAV is calculated as the ratio of the scheme’s AUM less liabilities and the number of outstanding units, the lower liabilities value increases the scheme’s NAV.
Fewer Distribution Channels: In case an investor plans to invest in a regular mutual fund scheme, the routes available are plentiful. This is because regular plans are available through both paper-based and online modes as well as from a wide variety of distributors. In India, the most favoured distributors for mutual fund investments have been 3rd party securities market intermediaries such as banks providing brokerage/demat facility as well as brokerages and broking houses. At present, direct plans are not available through these routes as a result the available distribution channels are relatively fewer. Though direct mutual fund investments can be made through both the paper route as well as the online route, the distribution channel options are limited. As per current rules direct investments may be made through a few select 3rd party securities market intermediaries, direct through the fund house/local representative office or RTAs such as CAMS and Karvy. As a result, a very small minority of Indian investors are currently investing via the direct route.
Systematic Investments and Withdrawals: Just like regular plans of mutual funds, direct plans also allow investors to use a variety of investment strategies. The commonest investment strategies include lump sum investments as well as systematic plans such as SIP (systematic investment plans), SWP (systematic withdrawal plans) and STP (systematic transfer plan). The STP methods requires you to have current instruments in a scheme of the same fund house whether regular or direct plan, while SWP implies that you are currently invested in the direct plan and are redeeming your investment systematically.
Growth and Dividend Options: Currently, direct plans are available to investors in the form of two different options – growth option and dividend option. In case an investor opts for the growth option of a direct mutual fund scheme, any profits made by the fund would be invested back into the scheme in order to generate further profits for the investor. The growth option thus witnesses increasing NAV as long as the scheme is making a profit and future redemption of the scheme units generates profits for the investor at a later date. The dividend option of direct plans is usually available as two separate variants – dividend payout and dividend reinvest. In case of the dividend payout option, when the scheme declares a dividend, the investor is liable to receive a payout directly into his/her account. The amount received would be dependant on the number of units that the investor holds. In case of the dividend reinvestment option, the investor receives additional units of the scheme depending on the applicable NAV and the total payout received.
Online and Offline Availability: At present, direct mutual fund investments can be made either through the paper investment route or the online investment route. In case of paper investment route, the investor has to fill out and submit the applicable investment forms along with the relevant documents at the mutual fund house representative office. In case of systematic investments, post dated cheques or ECS authorization needs to be submitted by the investor. The paper route of making investments does not allow investors to benefit from market movements as investors cannot accurately time markets. On the other hand, the online methods of direct investment allow investors to benefit from lower same day NAV if the investors can make his/her investment within the required cutoff time. The benefit of online investments is that the investor remains in complete control of his/her portfolio, which can help inculcate a sense of financial discipline in the investor. As mentioned earlier, the choice of distribution routes for direct plan investors is currently limited. However, the footprint of these plans is expanding and direct mutual funds are expected to account for a much larger proportion of total investments in the future.
Investing in Direct Mutual Funds: Hits and Misses
Though only a small percentage of investors have started investing in direct mutual funds during the past couple of years, the penetration of direct plans is on the rise and expected to increase further in the future. At present, direct plans seem to be most suitable for online investors who are internet savvy as this format provides the widest reach to direct mutual fund plans. If the current trend continues, the benefits of the online route and greater popularity of internet-based investments are expected to drive popularity of direct mutual fund schemes in the near term.
Direct mutual funds are currently favoured by investors who prefer to control and manage their own investments and do not want to pay additional charges to agents or brokers. These DIY investors are often few and far between as the mutual fund industry in India is still in its infancy. Going forward, as capital markets in India continue to develop, the average returns from mutual funds are expected to become lower as they come closer to the benchmark levels. However, for relatively new investors, investing by themselves in direct mutual funds might not be the best solution. This is mainly because the services of a broker or financial adviser would help new investors choose the most appropriate funds and develop a better understanding of what might work best for their unique investment requirements. At a later date, when today’s new investors become seasoned investors themselves, they might very well decide to shift to investing in direct mutual funds. Thus increased user acceptance of the solution is expected to drive future mutual fund investments.