Mutual Funds: The Cost of Using a Distributor Is Even More Than You Think

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“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

― Albert Einstein

In September 2012, SEBI vide a circular asked Mutual fund to provide a separate plan for direct investors. This separate plan would have a lower expense ratio excluding distribution expenses, commission, etc., and no commission shall be paid from such plans. The plan would also have a separate NAV. The idea was: Give self-driven investors the ability to buy into a fund without having to pay distributor commissions.

With the culling of entry loads in 2009, distributors were paid a part of the fund management fees. Many investors – at least the big ones – were unhappy to see large portions of fees given to distributors even when they went directly to the fund to buy. Thus the direct plan – to cut out the distributor.

The idea was: the fund would have the same portfolio, the same fund manager and the same name (with “Direct” in it). The only difference was: a lower management fee.

In line with the Circular, Starting January 2013, mutual funds started providing “Direct” option for all of their fund schemes, with a lower management fee. In a few months from now, we will have 5 year data to compare and contrast the difference in returns between the Regular option and the Direct Option of mutual fund schemes.

The Commission Imbroglio

Distributors are paid in two ways.

  1. When a new investment (Lumpsum or SIP) is initiated, fund houses incentivize the distributor by paying what is known as “Upfront Commission”
  2. Distributors are also paid a commission based on the value of investment, a fee that is known as “Trailing Commission”.
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Upfront commission is one time commission paid for bringing the investment to the fund house. But fund houses can generate income only if you stay for long. To ensure that the distributor doesn’t drag you to another fund, a commission known as trailing commission is paid.

Nothing is free and all these costs / expenses need to come from somewhere. Fund management costs (now including distributor payments) is deducted from your corpus as part of the running expenses. While in theory, expenses should come down as a fund the size of the fund increases, this is seldom the case. As the table below showcases, fund charges aren’t much different for funds with low assets under management to funds with large assets under management.

And it’s incredible that the difference between Direct and regular is the highest (0.91%) for the largest funds (assets more than 10,000 crores).

Is Direct Cheaper? Better? More Popular?

While Direct is cheaper than Regular as an option, it hasn’t quite taken off just yet among retail investors. Direct only 13% of the total money invested in mutual funds by individuals.But a majority of institutional investments are through the direct mode.

This could be due to the fact that most investors aren’t really knowledgeable about investing and would rather go through a distributor than invest on their own.

Individual Investors dominate when it comes to participation in Equity Oriented Schemes with more than 85% market share. And then, 62% of individual investor assets are held in equity oriented schemes.

But when it comes to “Direct Investing”, just 9% of Individual Investors in Equity funds  opt for “Direct” Schemes. In ETF’s and Fund of Fund Investing, Direct Investors account for 78% of the total assets, but the asset size is relatively tiny.

 

Investing “Direct” is even better than you think

It’s a foregone conclusion that “Direct” funds will have a better return than Regular given that there is a difference in the Expense ratios between them. The portfolio is exactly the same.

But you can’t just say the “regular” expense ratio is 2% and the “direct” expense ratio is 1%, so the difference in returns is 1% per year.

What is surprising to see is the difference in Returns are higher in 88% of Large Cap funds than just by comparing Expense Ratios. In other words, investors going Direct is much better than just the difference in Expense ratios between Direct and Regular versions of the same fund.

Here’s a review.

The above table showcases the average fees and the differential between Regular plan and the Direct Plan of the same scheme. The Universe used for the above calculation is “Large Cap Funds” and excludes Index Funds.

The average difference in expense ratio between the Regular Plan and the Direct Plan of the same fund is to the tune of 0.81%.

The one year return difference between Direct and Regular should equal the difference in Expense Ratio, Right? Wrong.

The difference is much higher: 1.04%! 

That means a “regular” fund investor loses by much more than the expense ratio, to the “direct” investor. This is since Expense Ratio is calculated on a daily basis and this compounds over time. In other words, the return is higher than what you save from Expense Ratio in itself.

While 1.04% a year doesn’t seem like much, over a period of say 25 years, you would have ended up paying 25% of returns to the distributor who helped you buy the fund. 

Such a fee is only justified if the distributor provides immense value through all of the time you are invested. Not just once.

In many cases, there’s no real advice, there’s just raw distribution. Buying on online platforms like “ICICI DIRECT” is simply buying the inferior Regular plans. Buying through a bank makes the bank your distributor, even many years after you’ve invested. You effectively pay these platforms a large sum of money over time.

An example: When you convert the difference into absolute returns, over 3 years, a investor investing in Motilal Oswal MOSt Focused 25 Fund (regular) for instance would have made 6.81% lesser than the “Direct” investor, due to the fee differential.

Do note that fees do change constantly and this analysis is based on current fees and not historical numbers which could be either higher or lower than what is calculated currently.

Don’t pay for what you don’t use

Distributors are important, if they help you select the right investments and hand hold you along the way. But most act simply like errand boys, who do the paperwork for you. Others only befriend you for the purpose of doing a transaction, but vanish afterwards.

There are now advisors that charge you a fee, but help you to buy direct funds instead. This is a more transparent model. If you’re happy with their service every year, their fees will be justified, and you’ll pay. Or else you stop paying and you no longer are hit. The regular funds don’t give you that freedom. Perhaps the future is in financial planning, advice and actual management – not so much in distribution.

The miracle of compounding returns is overwhelmed by the tyranny of compounding costs. – John C. Bogle

14 COMMENTS

  1. Yeah we understood that.. but what is the best way to buy Direct plans? Directly through the MF WEb-site?
    And there is no consolidation view of all the MF plans

    • Directly through MF web site. Then go to https://www.camsonline.com/InvestorServices/COL_ISAccountStatementCKF.aspx and enter your PAN and you’ll have it on email. You can also track this at sites like moneycontrol, valueresearchonline.com etc. (which are free).

      Consolidation of your accounts is value, but it’s not something that’s worth 1% a year; a 1% fee based system can be reasonably expected to do more work in terms of financial planning or such.

      • Thanks Deepak.. you made me realise I can save a ton of money.
        sometimes we just take some things for granted and dont put it on paper to see the difference.. I started to think differently when I put something on paper just like the one Excel formula you shared for calculating FV and PV .. thats excellent….

    • There is comprehensive statement from NSDL (NSDL Consolidated Account Statement) that comes every month. That’s a fantastic report which even consolidates across demat accounts and Mutual funds. Gives CAGR for mutual funds, comparison with previous month and much more.

  2. Dear Author of this article.
    How do you see Mutual Funds? A product for wealthy investor or tool for the common person to help grow the wealth over the longer term as compared to other traditional instruments.
    Does a distributor is just a sales person or all in one package whose income depends upon the future growth of a investors wealth?
    Do you think people in our country aware enough to take informed investment decisions themselves, execute them and regularly monitor them?
    A well-qualified distributor cum advisor will add more value to the overall portfolio of an investor rather than taking away 1% from returns.
    What percentage of investors are willing to pay fees?
    Do fee only advisors, who have access and good repo with HNIs and other wealthy people, have right to manage money, how come an investor investing 1 lac in a year pay fees and who will make him invest his/her money?

    Yes, the lobbying is very strong in favour of so called Direct advisors and planners but if you want this industry to flourish, then thought of just direct is very dangerous and questions the overall knowledge and skill of such people favouring it whole heartedly.

    • Does a distributors income depend on future growth in investor’s wealth? Yes. Does the future growth of the investor’s wealth depend on the distributor after the first entry? In many cases, they add no further value. But they continue to get paid. We think adding value is necessary.

      I think anyone in this country has the ability to take such informed decisions. Regular monitoring is a service that customers need to pay for – and most distributors (read: bankers) don’t do this anyhow.

      If the split was 50-50 between direct and regular it would be fine. If it’s just 13% for direct, then surely there is room for Direct to grow.

      • Mr. Deepak, I am a distributor and have more than 50 clients and all are first-time investors and had zero knowledge about MFs that too in T-15 city. I seriously disagree with ‘anyone in this country has the ability to take such informed decisions’. People don’t even know the difference between insurance & investments, how can they take decisions related to investments.
        Yes bank do not add any value but there are many like us who cannot ask for fees from retail clients and they cannot pay.
        Well informed investors can take decisions but a large section still needs advice that too at low cost and 1% of commissions are not bad but too much of direct promotion will confuse first-time investors. So, you are better placed, kindly promote both not just one.

        • I’m not saying that all distributors are bad; I’m just saying it’s not apparent that what they provide is value enough to pay for every year for the rest of your investing life. There are people who don’t know. They won’t even read this post. So my post will not reach them, and it will not impact people like you who are doing really good work and getting a reasonable fee for it.

          But for people who know, they will probably be managing their own investments or at least, can learn to do so. If so, this post helps them understand how much more they can make by going direct.

          I think both deserve to be promoted. But distributors promote themselves and own 91% of the retail eqiuty market. Therefore the 9% in Direct needs to be promoted too…

          • We just need to look at past 5 decades of trend in US mutual fund industry to see where industry will go. In US, low cost ETF were very small 50 years back. High cost funds ruled. The things have changed over the years and in equity category ETF’s are much larger than actively managed funds.

            Same will happen in India over the years. Market share of Direct plans will keep on increasing

  3. 1) Any Business needs a wide distribution network to reach mass.
    Today the AUM figure of 19 Lakh crores would not have been possible without the key role of distributors.

    2) Insurance & Investment is still a push product in India. Tier-2,Tier-3 & Rural Population are still not aware of MF and even if few know but are risk averse. Distributors play a vital role in creating awareness and educating them and executing the transaction in remote locations where there is not even a AMC branch & Investor Service center.

    3) Why only look at distributor commission , even fund management charges has compounding effect… If someone says “Had you invested 1 lakh in XYZ Fund in 19XX, today its worth 70 Lakhs…” then kindly do calculate how much the AMC would have earned in that period.
    Fund management charge is applicable even in the year of under performance or non-performance, none of the AMCs waive charges.

    • On point 1) I agree but look at the US. Vanguard is the biggest fund. It has no distributors. (Only advisors who get no commissions but charge the investor directly). Even they oly reached there first through distributors, then they went direct. India is only 9% direct which I think deserves to be 30% to 50%.

      ON 2) Things are changing, and while distributors will help now, eventually people even in Tier 2 and 3 will go direct.

      On 3) Fund management fees are acceptable, because the fund manager keeps adding value. He had to manage the portfolio! That’s why index funds are so cheap – the manager has no work! (In India, even index funds charge high, but in the uS there are very low fees. Or look at SBI ETFs)

      I don’t want fund managers to waive their fees. I just want the right to exit and not pay them fees for their non-performance. If I have a good fund manager but all the distributors I know are not good enough or won’t give me value, why should I pay them fees? I can keep paying hte fees to the fund manager for his performance wiht a direct plan.

  4. One aside regarding SEBI:

    I was thinking how did SEBI manage to effect this “Direct Funds” change in 2012.
    Very often, any such “logical” improvement can quickly take a political turn because of vested interests of lobbies and can get stuck and we are left scratching our heads as to why things are not moving in the right direction even with no-brainer improvements.

    In this particular case, I suspect it was the large companies with large cash holdings ie “corporate debt fund holders” who must have lobbied to have an option for direct funds. They were the ones who were investing directly already but had to pay for regular funds for no reason.
    Does not seem like something SEBI would do suo-motu for poor retail investors like us.

    That’s why you need to get organized, and kudos to orgs/activists like medianama/moneylifers and such for doing those things. In the US, ACLU and Electronic Frontier Foundation are fine examples of what meaningful changes organizations can do.

  5. On serious note this is not a matter of debate. If advisor is able to create alpha aka ‘Advisor’s Alpha’ of 1 % and capable to found and trust,aware and understand thoroughly than he can add ‘Manager Alpha’ too of 1 %. Total 2 % is the benchmark which one need to stick behind. If not than EVERY BIT OF EXPENSES charged to INVESTOR ‘GOD aka PLAYER’ is not sane and worthless. Either market forces will kick one out or Client will definitely in.

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