The Direct vs. Regular Debate

If you’re a mutual fund investor, you probably know that there are two types of plans you can invest in; the direct or the regular plan. In case you’re unaware of their definitions, here’s an introduction;

1. Regular Plan – This is when you invest in the mutual fund on the advice of a trusted wealth manager. The asset management company (AMC) shares a part of the expense ratio (annual management fee) with the wealth manager. Since the advisor is being compensated, the expense ratio of a regular plan is higher than that of a direct plan by the quantum of compensation.

2. Direct Plan – This is when you invest in the mutual fund directly i.e. without professional advice. The assumption here is that you thoroughly understand the mutual fund universe and do your own research. Naturally, the expense ratio is lower.

Broadly the difference between the two plans’ expense ratio ranges from 0.60% to 1.20%, depending on the type of fund. Assuming ABC fund’s direct plan charges 0.90% and the regular plan charges 1.70%, the direct plan’s return will always be higher by an annual 0.80%. Ergo in my opinion the following question is a bit silly; Is direct plan better or regular? That’s like asking what’s more Rs. 1,000 or Rs. 800? In value terms the direct plan of ABC Fund is obviously better, it always will be! While the direct plan would’ve been a no brainer if India’s mutual fund universe consisted of one fund, the reality is slightly more complex.

Here’s the real question; Do I need professional advice or can I build/manage my own wealth? The mathematical logic of hiring a financial advisor is simple. The value addition brought by them should consistently exceed the cost. In this case the incremental return should exceed the incremental cost of 0.60%-1.20%, and preferably delivered by taking a lower risk.

Disclaimer: I have a conflict of interest in the message of this piece. However as always, the intention is to still to educate, lay down facts and enable rational decision making. And in order to do justice to your mutual fund portfolio, the following facts have to be considered and understood:

1. The sheer depth of the mutual fund universe – There are over 2,000 funds in the MF universe. These are split into equity, debt, hybrid, and commodity funds. They are further divided into SEBI defined categories designed to fulfill specific objectives, and come with their respective corresponding risks. Even within the same category, you’ll find funds that are poles apart in terms of management style, types of risks taken, number of stocks, strategy, etc. This explains that as on the 31st August, the difference between the one year return of the best and worst large cap fund was 18.02%! Then you have different structures; close/open ended, growth/dividend. Navigating through the constantly evolving universe is time and knowledge intensive.

2. The frailty of chasing returns, rankings, and ratings – It’s fairly evident that the extent of ‘research’ for most MF investors is limited to checking returns, rankings, and star ratings online. Unfortunately, creating substantial wealth requires more. The probability of a fund ranked 1 retaining its position after a year is ZERO. According to a study done by the chief economist of the Federal Reserve Bank, MF investors who followed the ‘chasing returns’ strategy were losing about 2% per annum! Hence the good old saying ‘past returns don’t indicate future performance’. This is why investing on the basis on CAGR (historical) returns is not only futile, but dangerous (the cycle of buying high and selling low). Furthermore, star ratings are fickle and react to performance. Even publications and apps who give them strongly encourage further research. Identifying winning funds that’ll consistently compound over time requires a rigorous quantitative and qualitative selection process. The whole idea is to identify candidates that’ll do above average IN THE FUTURE. In other words, the idea is to be proactive (not reactive; much like relying on returns and ratings).

3. The risk of being penny wise pound foolish – While cost is an important element of investing, it cannot be looked at in isolation. As on 31st August, 2020 the difference between the 10 year return of the top and worst performing equity fund is an annual 20.23%! Both these funds are run by prominent AMCs with considerable assets under management. Even their expense ratios are similar. Being overtly cost sensitive is a damaging way to approach portfolio building. You don’t want to end up in a scenario where you’ve lost years of potential compounding trying to save pennies. Remember, it’s the continuous process of picking the right asset class, product, category, then fund manager that adds real value.

4. The importance of monitoring – Capital markets are becoming increasingly dynamic, complex, and multifaceted. There are several constantly changing variables that affect your mutual fund portfolios. And so the initial act of purchasing a fund is almost insignificant. Financial products cannot be treated like consumer durables (i.e. transactional). And this is why the question ‘What funds do you recommend?’ has far less utility than ‘What’s your fund selection process?’ OR ‘How do you monitor your recommendations?’ Immense value is created via dedicated monitoring; not just monitoring performance but monitoring the underlying reasons of that performance. It ensures objective fulfillment. Buy and hold only works if what you’re holding is still any good in the first place.

5. The softer aspects – According to AMFI data from Feb 2019, less than 9% of direct mutual fund investors remain invested for more than 5 years. In fact, 66% of these redeemed within two years of which 41% redeemed within one! The report goes on to demonstrate the correlation between increased market volatility and closure of direct folios. Considering that real wealth is made through decades of discipline, structure, and consistency, these are grim statistics. Behavioural finance has an astounding influence on the wealth generating ability of individuals. It can be extremely difficult to stay on course in choppy times, especially when there’s lack of guidance or limited conviction. And limited conviction usually comes from not being able to understand the underlying the reasons of why the portfolio is behaving the way it is.

6. Qualitative factors – Quantitative research (statistics) tries to use numbers to project the future through time-tested techniques. However, qualitative factors can render even the most advanced quantitative research useless. And therefore mutual fund selection has to be a combination of the two. For example, is the AMC process oriented or is it run by a star fund manager? What happens if the fund manager leaves? Have the promoters made bad integrity calls in the past? Is the AMC profitable? Etc.

Mutual funds are an amazing way with to build wealth. They have a rare combination of professional management, low cost, transparency, heavy regulation, liquidity, tax effectiveness, a small minimum ticket size, and at the same time the ability to generate stellar returns. Name one other investment product that offers all that! Yet somehow most people we meet haven’t had the best experience. Upon delving deeper, their experience is usually explained by one of the points above (or lack thereof).

With SEBI’s cap on expense ratios, ban on upfront commissions, and compulsory disclosure on amount of commission paid by the client (available in govt. provided NSDL/CDSL statement); the opaqueness around regular plans has vanished. Informed investors can finally choose an advisor basis capability without the constant worry of being shortchanged; at least when it comes to mutual funds.

In our opinion, it’s usually a good idea to partner up with a professional if you don’t have the time or relevant expertise. Working with someone capable and trustworthy can add immense value. A good advisor will transparently communicate their cost and demonstrate incremental value. Value is not just generated from mutual fund selection, but also through asset allocation, monitoring & re-balancing, estate planning, tax planning, and more. Perhaps it’s better to work with someone and reach 100 crores than get to only 60 crores by yourself.

Siddhanth Jain | Partner

BlueFort Financial