You have always been told to focus on mutual fund performance. While that is important, long-term investors in mutual funds can enjoy relatively better returns by choosing direct plans that have lower expense ratios. This is what our study of the performance of equity, debt and hybrid schemes (632 schemes in all) found. For the sake of the study, returns of funds — for both regular and direct plans — were compared since January 2013.

Lower expense ratio of direct plans benefit investors with an investment horizon of more than five years, in a meaningful manner. However, it is also important to pick the ‘right’ fund that manages to outperform its peers on a consistent basis.

For the uninitiated, a mutual fund is a pool of money collected from investors and ultimately managed by professional fund managers. To manage investors’ money, the mutual fund charges a fee. This, along with other expenses, is called the expense ratio or total expense ratio (TER).

Mutual funds typically incur two types of expenses. One is non-recurring expenses that are incurred during the launch of a fund. These expenses are borne by the fund house and not charged to the investors.

The second is recurring expenses — fees and expenses charged for managing the scheme. It includes investment management and advisory fee, trustee fee, marketing and selling expenses, etc. These expenses are calculated against the daily average net assets of the fund. The NAV of each day is actually calculated after accounting for such expenses and hence borne by the investors.

Cap on expenses

Under the existing norms, mutual funds are allowed to charge a maximum annual recurring expenses not exceeding 2.5 per cent of the fund’s net assets. While 2.5 per cent is applicable for equity funds, it is lower for debt and index funds at 2.25 per cent and 1.5 per cent respectively. An additional 30 basis points can be charged by the mutual fund if the inflows come from beyond the top 15 cities; another 20 basis on other permissible expenses; additional 20 bps in lieu of exit load. Besides, fund houses can also charge for the service tax paid on the investment and advisory services.

Direct plan

With the market regulator making it mandatory for mutual funds to launch ‘direct’ options in late 2012, investors got the opportunity to buy schemes directly from mutual fund companies at lower costs (expense ratio). The commission paid to intermediaries is excluded from the expenses charged to investors under direct plans, thus causing a difference in the expense ratios of regular plans.

Real picture

To understand the impact of the difference in expense ratios on regular and direct plans, we analysed mutual funds that launched direct plans in January 2013. 632 such schemes were shortlisted across categories, including equity, debt and hybrid. The returns were calculated from January 2013 till date. We found that, on an average, the difference in expense ratio between regular and direct plans for funds with a large corpus in equity-oriented funds, stood close to 80 bps.

This led to direct plans outperforming regular plans in all schemes. In the equity-oriented fund category, the difference in returns was 6 per cent on an average over the last four years for schemes with corpus exceeding ₹4,000 crore. So, ₹ 1 lakh invested in January 2013 in such schemes would have grown to ₹1.71 lakh under the direct plan and ₹1.65 lakh under the regular plan; based on average return of 65 per cent (point-to-point) delivered by larger funds over the four-year period in absolute terms. Franklin India Smaller Companies Fund, Axis Long Term Equity Fund and Franklin India Prima Fund topped the list among larger funds with higher difference (in absolute returns) of 11, 10 and 9 per cent, respectively.

Other relatively better performing funds too saw notable difference between direct and regular plans. For example, Invesco India Mid Cap, SBI Small & Midcap, and UTI-Transportation & Logistics delivered relatively higher returns during the period. The return in direct plans was higher, all thanks to the power of compounding.

The difference in the expense ratio between regular and direct plans was lower for debt funds than their equity counterparts. While the difference in expense ratio between regular and direct plans was higher for income and gilt long-term funds categories (71bps and 60bps, respectively), it was lower for liquid funds (12 bps) and floating rate income short term funds (26 bps). However, the difference in returns due to lower expense ratio is significant for debt funds where returns tend to be relatively lower.

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