- Direct plans save costs, and make a serious impact for a long term portfolio.
- However, there are several factors that an investor should keep in mind while taking that road. Else, the gains made by going direct will go waste.
- Going direct does not have to mean going without any help.
- Investors should choose the right mechanism of getting help for their planning, product choices, and portfolio maintenance to get full benefits of going direct.
In October 2012, SEBI came out with the proposal to create ‘Direct’ plans in mutual funds. In the weeks/months that followed, there was exactly one article that was published in a mainstream newspaper arguing AGAINST the proposal.
That article was written by me.
You can find the link to that article in the bottom of this essay. My concerns were two-fold – one, I was worried about the impact on the mutual fund business ecosystem. And two, more importantly, I had concerns that investors would be swayed by saving on expenses and compromise on portfolio quality.
In the seven years since then a lot has happened, and my views on this topic have evolved to keep pace with the events. In this article, I want to write about how I see the landscape today, and how investors should approach the question of direct vs regular when it comes to mutual fund investments.
But first, let me give a brief overview of what direct plans are and why this decision is important.
If you already know about direct plans and what they mean, you can skip the section below, and go directly to this part of the article.
What are direct plans of mutual funds?
Mutual fund investments are not free of cost. When an investor invests in a fund, they are ‘hiring’ a fund manager in a fund house to manage their money for them. And for this service, there is a fee that the investor pays over time. This fee is called the expense ratio of the fund (or TER – Total expense ratio), and it is a percentage of the investment amount. If the TER of a fund is stated as 2%, that means, on an annual basis, 2% of the investment amount goes to the fund house as fees. For example, if a person invests Rs 1 lakh on January 1st in this fund, and stays invested until January 1st of next year, they would have ‘paid’ Rs 2,000 as expense to the fund house, assuming the NAV remains the same.
Now, this expense is not charged directly – the fund house does not raise an invoice to the investor and expect them to pay the bill. It is debited from the investment on a daily basis as a reduction of the NAV (price per unit) of the fund. For example, if there are 200 business days in a year when the fund declares NAV, and the expense ratio is 2% then the NAV is reduced by 2 divided by 200, which is equal to 0.01% everytime the NAV is declared.
This is actually an ingenious method of charging the investor – for the simple reason that an investor pays only for those many days (on a pro rata basis) that they are invested in the fund. If an investment is held only for, say, 6 months in the above fund, they end up paying only 1%, not 2%, as an expense.The expense thus charged, goes to a whole host of people and entities in the food chain. There is the fund house (AMC – asset management company), of course, which is in charge of the whole thing. Then there is the Registrar and Transfer agent, the book-keepers for the fund houses, and there are custodians, and, finally, the advisor or the distributor of the fund.
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In 2012, SEBI looked at this expense structure and said, well, not every investor is using the services of an advisor or a distributor, and so, why should they bear that portion of the expense. So, they mandated that, starting January 1, 2013, AMCs should launch a second version of every scheme that they have – a ‘direct plan’ version that will be exactly the same as the ‘regular’ version, but will charge a lesser expense ratio – essentially, cost less to the investor.
How much lesser? SEBI said that they should cost less exactly by that amount that the AMC pays to the distributor for that fund. So, if an AMC pays a distributor 0.8% for the fund with the 2% expense ratio, then the direct plan of the fund will carry an expense ratio of 1.2%.
So, in one stroke, SEBI created a lower cost option for all mutual fund investors and provided them an option to save real money. How much? What was the impact for investors?
Impact of direct plans – the positive
The savings to investors in direct plans are undoubtedly real. When an investor invests in mutual funds, especially for the long term, the investment keeps growing, hopefully, every year. The expense ratio applies to the current value of your investment, and hence, the real monetary value of the costs that an investor incurs increases. Any reduction to this cost, thus, has a ‘compounding’ effect in terms of savings as well – resulting in significant value accretion to the resulting corpus.
How much? Let’s find out with an example.
Some myths about direct plans
Myth: Direct plan NAVs are higher, so they are more expensive – It is true that direct plan NAVs are higher than regular plans, but that is because they grow faster. And they grow faster because their expense, or cost, is lower! So, the NAVs are higher because they are LESS expensive. At the end of the day, absolute NAV values are not useful – only the difference between redemption NAV and purchase NAV matters, and that will be higher for direct plans (meaning more profitable) than for regular plans.
Myth: You can invest in direct plans only if you directly to the mutual fund companies (AMCs) – this used to be true until a few years ago, but it’s no longer true. There are several digital platforms available for investing in direct plans in an aggregated manner.
Myth: Direct plan of a fund has a different portfolio – This theory insinuates that since direct plans are cheaper, they are not as well-managed as their regular counterparts. This is absolutely false. The portfolios of direct plans are identical to that of the regular plans and are managed equally well.
A lot of illustrations in this regard are done with dummy funds and assumed costs. At PrimeInvestor, we wanted to take a very plausible real-life portfolio and look at the difference between investing in direct vs regular. We assumed a SIP investment of Rs 20,000 per month for five years starting November 2014 (until October 2019).
Here is the portfolio – one that allocates 75% to consistent equity funds, and 25% to a good debt fund –
An SIP of Rs 20,000 a month into this portfolio over the last 5 years would have had these different results between direct and regular plans of these funds:
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As you can see, the difference in the resulting value of the portfolio is significant. And the longer an investor continues this investment, the wider this difference will become. If the same difference of 0.74% continues for a typical long-term investment time horizon of 20 years, the difference will be between Rs 1.7 crore (direct) vs Rs 1.5 crore (regular).
This is a plausible, real portfolio, and the values are absolutely real – so, trust me, investing in direct plans is definitely worth considering.
Impact of direct plans – the not-so-positive
SEBI created direct plans to benefit those investors who did not use the services of an intermediary. However, there is this thing called an ‘induced effect’ – which means when a benefit is created for a certain segment of the population, that segment will grow since more people will join in to enjoy the benefit.
That is exactly what happened with direct plans as well. People started investing in direct plans regardless of whether they were savvy enough to do so. And telling others about this ‘wonderful cost saving’ method – without themselves realizing nor informing the others about the pitfalls of doing so. The advent of several bare-bones direct investing platforms furthered this rate of adoption.
The problem shows up mostly in terms of how fund choices are made. In my experience, investors are often swayed by common-place biases when picking funds for their portfolio. Some of them are recency bias (looking at the most recent performance of a fund), ratings bias (just going with top rated funds), and fund house bias (going with big brand names). There are other, more fundamental issues as well – such as not understanding returns or risk measures from a basic financial math perspective – things like the difference between absolute and annualized returns, point-to-point and rolling returns, and so on.
Consequently, you have a situation where investors are tempted to take a low-cost option and often end up paying the price for it.
How much? Let’s look at a scenario again.
Cost of not investing right
To figure out the cost of an investor not investing in the right portfolio with astute fund choices, we did an interesting exercise. We went back 5 years, and put together two portfolios. One we called the ‘Popular portfolio’ and the other we called the ‘Good portfolio’.
The ‘Popular portfolio’ consisted of schemes that an investor would have likely selected at that time by themselves – going by recent performances and star ratings. The ‘Good portfolio’ would have schemes that would have been put together by someone with above-average acumen in this regard (be it an advisor, or the investor themselves) by using factors such as rolling returns and appropriate risk measures.
First, here are the two portfolios.
The Popular Portfolio:
The Good Portfolio:
Once we had these portfolios, we ran the numbers on both the portfolios using a familiar investment pattern – a SIP of Rs 20,000 per month for 5 years – starting November 2014, until October 2019.
We ran it across both variants of the two portfolios – direct as well as regular.
Here are the results:
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Now, what do these results tell us? Simple – the difference between Direct vs Regular was completely overshadowed by the difference brought about by fund choices. Even if an investor had gone with regular funds, they would have come out far ahead compared with going direct, if the latter resulted in poor fund choices.
Thus the benefit of going direct should be evaluated in the context of having put together a good portfolio in the first place. There is a definite and more significant cost to bear if portfolio design and fund choice decisions were not made correctly.
So, how should you decide which path to take?
It is a natural consumer instinct to want to save cost – especially when we are getting the exact same product at a lower price. However, it is important to understand what we are giving up when we do so, and identify ways to lessen the impact.
But first, let’s try to understand what it takes to invest well.
What it takes to invest well
By ‘investing well’ what I mean is deploying your money in a way that works for YOU – that is, invest in a way that suits you, choosing good products and making good portfolios, and helps you reach your financial goals over time.
What that takes is to do three things well – understanding investment arithmetic, understanding the universe of products, and being able to manage your investments over time.
Understanding investment arithmetic: this is nothing more than basic financial numeracy – knowing what it means by terms like compounded annual growth rate (CAGR), effect of inflation, time value of money, etc. Essentially, the ability to do the basic math required, for example, to figure out what amount needs to be invested over what period of time assuming a certain quantum of annual return. Or to figure out how much is required to retire in ‘n’ number of years given the effect of inflation and growth potential. There are calculators available aplenty on the web – the least that is required in this regard is the ability to use those calculators to find out whether you are numerically on track to your financial goals.
Understanding the universe of products: As I indicated in an earlier article the world of investment products available to regular investors is growing every year. An ability to understand this universe is critical to be able to invest well. And by this, I also mean the ability to evaluate products, compare them with one another, and figuring out the subtle fineprints about them. This also means understanding the need for separation of concerns (such as long term and short term products, and protection and growth products). And this also means knowing methods of evaluating products using parameters such as rolling returns and risk ratios.
Most importantly, understanding products means the ability to choose which products (from among the good products) would suit the needs of a particular investor’s portfolio – in terms of risk profile, time-frame, goals etc.
Ability to manage: Market-linked products do not live in a static world. The market keeps evolving around the products, and it is important for investors to be able to keep up with changing times. This is especially true of long-term portfolios such as education and retirement portfolios. Upkeep of portfolio is essential to ensure good returns (as Vidya Bala pointed out in this article).
What could go wrong
It should not be too difficult to derive from the above section as to what could go wrong if a person does not possess one or more of the above skills and still chooses to go with direct plans.
If they do not understand investment arithmetic, they are likely to plan poorly and either under invest or have an incorrect interpretation of their own portfolio’s performance.
If they do not understand the universe of products, they will choose poorly and, as we saw earlier, have an ill-designed portfolio that is either filled with bad products or those that are ill-suited to one’s requirements. More than likely, they will invest in rank bad products in the market lured by sales talk and end up throwing money away.
If they can understand investment math and are adept at analysing products, if they do not have the time or patience to maintain and manage their portfolio over the years, their investments will stagnate or waste away and eventually become a bad portfolio.
In my experience, the overwhelming majority of investors who seek the cost benefit of direct plans fall under one or both of the first two categories, and between the two, the second – where an inability to understand and analyse products (or a lack of time to do so) results in poor investment choices. For such people, having time to manage their portfolio is a wasted opportunity since they do not have the skills to do it.
How to protect yourself
Given this scenario, how should you go about protecting yourselves and ensuring that you have a healthy portfolio? Simple – get help, as needed. And in the form that is comfortable to you. There are several options available:
- Simple choice is to avoid direct and go with regular plans – but if you do this, ensure that you go with a service or an advisor that provides you with all the support for planning, portfolio design, and maintenance. You are paying good money, and you deserve nothing less than full service.
- Go with a robo-advisory platform – In my opinion, this is not a great choice as things stand now, but nevertheless it is one of the options for you to consider. There are several direct-investing platforms that have what are purported to be robo-advisory platforms. Please evaluate them, and ensure whether they provide continuing support for maintaining your portfolio before signing up. More importantly, understand how these platforms are planning to monetize the services they provide, and realize that if it is too good to be true, it is probably not a good idea.
- Go with a registered investment advisor – The number of RIAs in the country is growing, and you may be able to find one who can serve your needs in terms of planning, design, and management. If you go this route, make sure that the cost you incur is either a fixed rupee amount or is around 0.5%. Else, you will lose any cost advantage that you get by going with direct plans.
In short, it is imperative that you realize the area(s) that you need help and seek it in one way or another.
[Note: A quick plug about PrimeInvestor in this context – we are a completely new way of tackling this problem. Our research will ensure that you make great choices when it comes to product selection and portfolio design, and our continuing support will make sure that your portfolio always stays up-to-date, thus solving at least two of the three problems I mentioned above. And all this will be provided by a highly-talented, experienced, totally independent group of experts, and most importantly, will be available at the lowest price point – a fixed subscription cost – compared to all the other options above]
The mutual fund eco-system has come a long way over the past 7 years since direct plans have launched. There are plenty of platforms and transaction options available now compared to 2012 when this was announced. However, the problems of product analysis, financial planning, and portfolio management remain as they did back then.
As the situation stands now, it is a truism that direct plans save money for investors – they were designed to do so. However, an investor choosing to use them without any help is likely to cause their portfolio to be sub-optimal. Hence, for an overwhelming majority of investors seeking to save costs and boost their returns by investing in direct plans, my simple advice would be to ensure that they have a steady source of help/advice/counsel for building and managing their portfolios.
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