Navigating the maze that is personal finance

Monday, 23 January 2017

A tool to calculate the impact on returns if you choose a direct plan over a normal plan of mutual funds

There are two ways to invest in a mutual fund: invest with the fund house directly (using direct plans) or investing through an advisor, broker or distributor (using normal plans). The expense ratio of normal plans is higher than that of a direct plan since you go through an intermediary who is paid a commission in the normal plan. On an average this expense is higher by approximately 0.5%, in some cases it is as high as 1%. Why are we discussing this. The expense ration plays a very important part in the returns that you will get from your chosen mutual fund.

So should you invest in a direct plan or a normal plan of mutual fund?
Looking at this question from a purely financial standpoint, you should invest in a direct plan. As mentioned earlier the expense ratio of normal plans is more than that of direct plans. This means that over time, the returns accumulated in a direct plan will be more than that in a normal plan.

I have created a calculator to help you understand the compounding affect of the difference in expense ratio. You need to enter your monthly SIP contribution, expected rate of return per annum, expense ratio of normal plan and the expense ratio of the direct plan you are considering in the calculator.  In the example below I have considered a monthly SIP of  ₹10,000. The expected rate of return per annum is 12% and the expense ratios are 1.4% and 0.8% for normal and direct plans respectively. In this example the expected rate of return for a direct plan is 12% that of the normal plan is 12% minus the difference between the expense ratios of the normal and the direct plans (12% -(1.4%-0.8%) = 11.4%)

As you can see from the image below, the difference between the absolute returns grows with the increase in SIP tenor. The difference in the balance between a normal and direct plan was ₹275,260  at the end of 15 years. This difference increased to ₹764,102 at the end of 20 years.


You can download the direct plan versus normal plan calculator here.

That was the theoretical way of looking the returns from direct versus normal plans. Even if you look at the 3 year historical performance of the top 5 funds (as per Value Research) you can see that the direct plans have performed better than the normal plans.


Fund

Expense Ratio (%)

3-Year Return (%)

DSP
BlackRock Micro Cap Fund - Direct Plan

1.87

43.4

DSP
BlackRock Micro Cap Fund - Regular Plan

2.53

42.4

SBI
Small & Midcap Fund - Direct Plan

1.32

40.82

SBI
Small & Midcap Fund

2.36

39.07

Reliance
Small Cap Fund - Direct Plan

1.21

38.02

Reliance
Small Cap Fund

2.06

36.73

Franklin
India Smaller Companies Fund - Direct Plan

1.14

36.29

Franklin
India Smaller Companies Fund

2.44

34.57

Mirae
Asset Emerging Bluechip Fund - Direct Plan

1.6

36.27

Mirae
Asset Emerging Bluechip Fund - Regular Plan

2.37

35.01

But which funds should I invest in?

This is where the argument of investing in a direct plan versus a normal plan gets tricky. Performance of mutual funds varies quite a bit what fund you choose to invest in is critical. This choice can lead to a difference of as much as 4-5 % in the long run. The difference in the expense ratios of a direct versus a normal plan (and the corresponding difference in returns) will be a secondary consideration at best.

In conclusion
So if you know which fund you want to invest in, you should go ahead with a direct plan. If you need to rely on someone’s recommendation then a normal plan would probably make more sense for you.
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