A mutual fund is a service that a fund company provides to you. This service is paid for by money that is deducted from your investments. For equity funds, fund companies can charge in slabs that go from a maximum of 2.5 per cent to a minimum of 1.75 per cent, along with extra allowable expense if they can hit a certain level from towns and cities that are smaller than the 15 largest in the country. Additionally, there's also service tax, which will increase a little bit with GST. These factors can raise the high point of expenses to just short of 3 per cent.
While the rate is expressed on annual basis, the money is deducted every day in small amounts so that the annual charge adds up to the full amount. This money goes to the fund company, with some of it eventually going to the fund distributor who sold you the fund. While it is certainly arguable that mutual funds charge too much, the deduction is equal for all investors in a given mutual fund.
Or is it? Well, not really. The catch is that expenses are equal for a single fund. However, all funds come in two variants 'regular' and 'direct', which are technically separate funds but which manage your money identically. Regular funds are sold by distributors, while direct funds are sold directly by fund companies to investors. So in direct funds, there is no intermediary who has to be paid a commission. Really, the situation is identical to almost any other product or service--if the manufacturer is supplying directly to the customer, then the cost can be lower.
Except that in this case, the implication of lower costs are a lot more interesting and yet complex than just getting a cheaper pair of shoes from a factory outlet. Unlike the shoes, there are both pros and cons to getting a product cheaper when that product is a mutual fund. Firstly, the lower cost translates to higher returns on your investments. Moreover--and this is the crucial part--the higher returns keep compounding. That means that when less expense is deducted, your investment is worth more. That higher amount itself earns higher returns, and so on, over years. And the returns of every year are themselves higher.
The difference between direct and regular returns tends to be tiny. Over the years, it builds up, although not to a truly substantial level. Direct funds were launched in January 2013, obviously by government fiat. Let's look at returns in a typical five star rated equity fund since that time. The annualised returns have been 23.83% in the direct plan and 22.94% per cent in the regular plan. That doesn't look like much. However, over these years, an investment of Rs 1 lakh would grow to Rs 2.53 lakh in direct and Rs 2.45 lakh in regular. That's an extra Rs 8,000 on Rs 1 lakh in four and a half years.
That's money, but actually not too much of it. You should think of that as the money paid for the services of the distributor because that's exactly what it is. The knee-jerk reaction of always going for the cheapest option would not serve many investors well, except for knowledgeable do-it-yourselfers.
To understand the choice, let's see what kind of an investor is suited for direct investments. It would have to be someone who understands what kind of mutual funds are needed for different kinds of investment needs, is capable of researching these independently and come up with a list of funds to invest in, and then go through the process of actually investing without the help of an intermediary. After one starts investing, whenever the markets fall and investment values come under pressure, an external source of advice can help one stay the course.
Does this sound like you? If it does, then you could earn the extra buck by investing directly. But if you are anything resembling a new and inexperienced investor, then may be you will be better off with a regular plan. Of course, this leads one to the question of whether it's easy at all to find the right kind of advisor, but that's a topic for another day.