Should you go for direct plans or regular plans of mutual funds?

You all know that high MF expense ratio (also called total expense ratio or TER) impacts returns – especially in categories where returns are in single digits themselves. You also know that direct plans deliver more than regular plans as TER is lower for direct plans than regular plans. So, let’s go to the next step and try to answer three better and more important questions.

1. Which categories of funds have unusually high TER? Should you avoid them – be it regular or direct?
2. In which categories of funds is the TER difference between regular and direct too high? And are you better off staying with direct in such categories?
3. Know where the TER differential is high in some popular/large funds.

Before we get into the details, some points to note:

• We have split the study into equity, hybrid, and debt categories for ease of reference.
• We had to avoid FoF (including overseas FoF) as the true nature of expense will not be known without the cost of the underlying fund. So, commenting on this category without final performance (NAV captures all expenses) may not be correct.
• We took the average TER of last 3 months ending August 2020.
• We have given the difference of the simple average TER of regular and direct. We think this will be more appropriate than weighting them against AUM because, the high TER funds (likely with lower AUMs) are more likely to be pushed to regular-plan-investors by their distributors, especially banks.
• We have, however, stated the weighted expense ratio differential so that you get an idea of the how much you get to save (or lose) in equity, hybrid, and debt.
• This is not a buy or sell call on funds. You will need to use our MF review tool that already takes into account cost factors to evaluate funds.

NOTE: This is NOT an attempt to stoke the raging debate on whether you need an advisor or not. It is rather an endeavor to empower you to make informed decisions on choosing funds, irrespective of whether you go to a distributor or do direct.

Debt funds

While equity funds are more popular, the TER factor is more impactful in debt funds than in equity, given that the former delivers single-digit returns in the 6-9% range. Hence, we’re starting with the debt category. We are splitting this as follows –  one, categories that have high TER per se, even under direct. Two, those categories where regular is quite high and therefore direct may make more sense.

The table further below gives you the respective category average expense ratio of difference debt funds for direct and regular. The following observations are worth noting in this:

On high TER (even) in direct

• Categories such as credit risk, medium duration, medium to long duration, long duration, gilt, and dynamic bond have an average TER of over 0.5% even under the direct plan. For a debt fund, this TER is not insignificant. If you hold any of these funds, performance metrics will be key to determining whether these categories are good to hold in the first place.
• Specifically, categories such as medium to long duration and long duration which do not have much of dynamic duration management  (unlike dynamic bond) nor credit management (like credit risk or medium duration) have relatively high expense ratios for just managing duration within a limited range.

In the above-mentioned categories you have two choices –  one, to stay away from such categories altogether or two, monitor your fund performance closely to know if returns are not pulled down by high cost. Here’s what we would suggest when it comes to such categories:

• Credit risk needs lot of careful navigation. It is not worth the cost, in our view. If you are a DIY investor, the best is to stay away, even with direct.
• Similarly, without much value-add from medium to long or long duration categories, a high fee can be a dampener in these categories. You may not lose much staying away. Besides, ETFs such as Bharat Bond ETF (longer tenure) may compete more effectively with lower expense ratio.
• With gilt funds, you might still want to do your bit of research and go direct as the regular expense ratio can pull down overall returns higher than in other categories.
• Medium duration is a category fraught with risks, compounded by higher TER. Unless you have sound research advice, the risk calls for caution and if you are not a PrimeInvestor subscriber, you are better off staying away from this category.

On high differential in regular plans

TER of regular plans of debt funds are higher than direct plans by 48 basis points (and 44 basis points if weighted with AUM). When a regular plan’s expense ratio in debt is higher than 1%, they can clearly pull your returns if your fund does not perform well.

The following points are worth highlighting and noting in regular plans.

• The same categories that we mentioned earlier as having high TER in direct also have high TER in regular plans
• The additional category where TER is above 1% in regular is short duration. This is a category that is much lower cost-wise when invested through direct.
• As a rough thumb rule, where the differential is over 50 basis points in regular, you need to question your advisor about the value add coming from significantly higher distribution fee. If not, you could ask for other categories such as corporate bond, banking & PSU or lower duration funds suiting your risk appetite and time frame. The regular plan TER of these categories are not way higher than their direct plan cost.

There are 3 broad points you need to know before we move to the other categories.

• Most categories with institutional money will have low TER. This is because it is a game of large volumes for the AMCs here. Liquid, ultra-short, and money market categories are examples.
• It is primarily because of lower cost of such institutional plans that many of the accrual strategies with short duration yield reasonably well and compete with even duration and credit strategies in returns. You can check data on this article on accrual strategy.
•  Fund expense ratio goes down with AUM. But there can be exceptions to this. Listed below are examples of debt funds with over Rs 10,000 crore AUM where the regular plan TER is higher than direct by over 50 basis points. We view these as ‘push’ products i.e. the AMC is trying to push these schemes, with higher distribution fee (than the category average), large AUM notwithstanding.

Many of you have asked us about some of these funds and their lower rating or call in our ratings and review tool. You will now know a host of factors go into providing you our researched output.

Equity funds

On an average, the regular plan TER of equity funds is higher than direct expense ratio by 1.03 percentage points (90 basis points if AUM weighted).

The numbers stack up more evenly in the case of equity and hence we are not doing any deep dive into categories nor splitting them in terms of direct and regular. The following points are noteworthy:

• The expense ratio largely follows risk. Higher risk categories have higher expense ratio, specifically in regular plans, suggesting that AMCs need them to be pushed.
• Sectoral, thematic, small cap, focused, midcap, large & midcap are examples in the regular plan.
• Interestingly, even the large cap space appears to have become a segment that needs more ‘push’ going by the over 1 percentage point under TER in regular plan.

What to make of equity TER?

• Expense ratio is not a game changer within the equity category – unless of course you take the index fund route.
• Since the TER does not massively vary within equity schemes, rather than focusing on which category to add or avoid based on TER, you will do well to mix strategies well and ensure you pick funds based on consistency and performance.
• Direct plans clearly score over regular plans and for those who have the acumen or take the right support (read Prime Funds 😊), it can make a difference to long-term wealth building.

Here’s a detailed review of expense ratio mutual fund.

Interestingly, in equity funds too, there are good performers that are expensive. The funds below have an AUM of over Rs 5,000 crore and have a regular plan TER that is higher than direct plan by 1 percentage point.

These funds will clearly show far superior returns through the direct route than the regular plan. For example, in the data below for Axis Bluehip, a near-9% higher corpus through a SIP of Rs 1 lakh from 2013 (start of direct plans) to date can make a decent different to your corpus.

Hybrid funds

Now, here’s a category that tries to do many things. And therefore, it does not come particularly cheap. As data below will show you, four of the six hybrid categories have TER of over 1 percent even in the direct plan. And five out of six categories have TER of over 2 percent under the regular plan.The regular plan TER is higher than the direct plan by an average 1.05 percentage points (0.75 percentage points on a weighted AUM basis).

We have already discussed in our article on multi-asset allocation funds that a simple mix of equity and debt and gold has delivered higher returns. Let us now just do a simple back of envelope calculation of a 60:40 equity: debt proportion (which many of the above hybrid funds have).

The average TER of equity direct plans is around 1.12% that of debt is about 0.39%. A 60:40 mix gives us a 0.8% in expense ratio. Now look at the above categories and figure which one (other than arbitrage which is not comparable to a 60:40 strategy) has a lower direct TER than this mix? None!

Therefore, the bottom line here is simple: Unless you find a hybrid category appealing in terms of its strategy and the fund you use in such a category is a consistent performer, hybrid funds are expensive! Going by underperformance in categories such as hybrid aggressive, you would need to be selective in using hybrid – on a case to case basis. When you are sold a hybrid plan, you might want to ask what happens if you take a simple equity and debt product separately instead.

Hybrids with high expense ratio differential

And because hybrid funds are expensive, and are marketed as ‘all-in-one’ products, there is more ‘push’ for it. Given below are funds with over Rs 1,000 crore AUM and TER differential of over 1 percentage point. You will find some of the ‘popular’ schemes here.

In almost all the cases above (barring one), you will find direct TER to be below 1 percent, lower than the category average. However, the regular plan pushes the cost significantly for those who seek distribution services.

How PrimeInvestor recognizes expense ratio

TER is among the key factors we consider when assessing funds. It is more so in debt and hybrid and to a limited extent in equity. Therefore, funds with high TER, direct or regular, will automatically get penalized.

However observing the increasing differential in TER,  in our latest review (results of which will start flowing from next week for subscribers only), we have gone one more step in terms of highlighting to you where you should go for direct instead of regular plans. This will be available in our review tool early next week –  we will sound you off on the same.

Besides the above, in some time, we plan to put out a page – a ready reckoner – where you will find the total expense ratio of regular and direct plans, and their differential. This will help know the excess TER you pay for a fund, compared with peers. Of course, you will need to also verify our MF review tool to know our overall call. But this will be a good ground for you to be conscious of whether you are sold products with higher cost.

You may use the category average costs mentioned above as a rough benchmark to know where your funds stand. However, doing so without considering fund performance will lead to incorrect decisions. Our Review tool as well as Ratings consider all of them appropriately weighted. We request you not to ask queries based merely on TER and instead rely on our Review tool to help you!