/ Analysis

What is The Difference Between Regular and Direct Mutual Funds?

If you are even vaguely familiar with the world of mutual fund investing in India, you will know that there are regular mutual funds and direct mutual funds. They are not two vastly different entities as much as they are two different versions of the same entity. What makes them different? The expense ratio.

Each mutual fund has an expense ratio attached to it. The expense ratio is the annual fee that the fund charges its shareholders to cover the costs incurred by the fund. This includes management fees, administrative fees and operating costs. This is a reasonable cost, given that there is a fund manager who is (hopefully) working hard at increasing your returns.

For direct funds, the expense ratio is usually between 0.5 - 2%, but for regular funds, the ratio is higher (usually by another 0.5-2%) because it includes a distribution cost. This cost is effectively the commission that is paid to the person or entity that signed you up with that fund in the first place. This could be your financial advisor (most IFAs work on this model), your relationship manager at your bank who encouraged you to sign up for mutual funds without explaining the difference between direct and regular funds, or it could be a robo-advisory platform that is open about the fact that it receives a commission.

2% might not seem like a lot, but it is 2% on your compounded returns for the lifetime of the fund, which usually ends up being a lot. Some people don't mind paying that, especially if that fee is being charged by a financial advisor. As one friend who has such a financial advisor told me, "My relationship with my IFA goes beyond 2%. If he can pick the right funds and get some of the best returns in the market, I am okay with foregoing that 2%. And besides, the kind of relationship we have today has evolved into something special. He is more like a financial therapist, and that is something that can't be replaced."

Some people, unlike my friend who is very aware of the difference between direct and regular funds, don't even know that there is a difference. The commission-based model often operates very much in the realm of "hidden" fees, where an investor with little background knowledge has to really read the fine print to understand that this fee is ensconced within the expense ratio. For instance, people with large bank balances are called by their relationship manager or bank's asset management division to ask them if they would like to invest in mutual funds. Their incentive to sign a client up reduces drastically if the fund is a direct fund, and therefore many of them don't present it as an option to unwitting clients.

This hidden cost model that is fueled by encouraging the ignorance of consumers is what makes regular funds potentially and possibly unfair. In today's world of rapid technological innovation and growing levels of transparency, this model will become increasingly irrelevant unless the distribution model is presented in a different framework. That is what some robo-advisory platforms investing in regular funds are claiming to do, stating very openly on their website that they receive a percentage of commission directly from the Asset Management Companies so that they can make their platform free for users. But it's important to remember that the platform isn't free for users. The commission paid to them by the AMCs still comes from the investor. The chain of transactions happens in such a way that it looks like the investor is not paying, but that is a misleading notion.

This seems unfair. Why does this model still exist?
Direct mutual funds are a relatively new option in the Indian financial markets. They were introduced in 2013, and service providers in the industry are still realigning their business models to fit this new investment strategy. The distribution-based model has been around for ages, and some (like my above-mentioned friend) argue that if you have a very good financial advisor and planner, the extra 2 or so percentage doesn't matter, because it's worth it.

Another reason why this model still exists is because there is still a lack of information, especially amongst people who don't already have some kind of investment or finance background. This is compounded by the fact that investing directly in mutual funds is still not completely easy. A bank, for instance, is far more likely to complete your KYC registration process if they stand to gain a commission from it. Many people, however, are becoming more aware of the discrepancy between regular and direct mutual funds, and are moving towards direct funds. There will likely be a growing number of services that will appear in the next few years making direct investments far more seamless and easier.

So what other options exist?

Many DIY investors have begun doing their own direct mutual fund investments, relying on their own financial acumen and education, along with research tools and websites to build and rebalance their portfolios. They typically use one of these direct investment platforms, and use portfolio tracking and management tools like SimpleMoney.

Some investors go with robo-advisory platforms to not only execute their investments but to also get advice on which funds to pick. They pay for these services either as through a subscription, or per transaction, or as a percentage of their portfolio.

There is also a relatively new and growing class of financial advisors who have eschewed the commission model for a fee-based business plan. These SEBI-registered RIAs charge a fee from their clients, usually as a percentage of their portfolio. In many cases, this works out being cheaper than investing in regular funds. However, some investors are more reticent about such a model because it involves executing a transaction (writing a cheque or initiating a NEFT payment) to their advisor, making it seem like it is more expensive. With regular funds, the investor doesn't feel like she is paying because the money is deducted automatically and often without her agency. This is mostly a psychological phenomenon, which SimpleMoney's financial pundits believe will go away with more investor education and awareness.

What should I do?
The only real and valid argument that exists in favour of regular mutual funds is if you already have an advisor whose contributions you value greatly, and who charges his or her fees as a commission. Maybe this person handles a wide range of your assets, going beyond mutual funds, and you don't want to have to find someone else. Finding a good financial advisor can be really difficult, and it involves a lot of trust and understanding and if you're reluctant to leave, it might be worth staying. Also, given that times are a'changing, it is possible that your advisor might consider moving to a fee-based model as some already have started doing.

But, if you don't have such a beautiful advisor-client relationship in your life (don't worry, many of us don't), go for direct mutual funds. If you are a DIY investor, there are plenty of platforms (free and fee-based) that allow you to make investments, and even provide you with robo-advisory services. If you have a large corpus of assets and want more personalised (and human attention), there are some very successful fee-based financial planners in India who are transparent about their costs and who help you really understand how much you are paying for advice and guidance.

But, if you're still interested in going with a regular fund, here's a post outlining some of the most popular regular investment portals out there.

Either way, you're going to need a place to track your portfolio. Do it on SimpleMoney. It's automatic, and free!