Switch To Direct Funds

One of the reasons you invest is to get better returns and the mutual fund category is among some of the options to do so. Here too, switching from a regular to direct plan can lead to better gains. The article explains how

There are very few factors that impact the future returns of a mutual fund scheme the way expense ratio does. Lower the better. Therefore, if everything remains the same, lower expense ratio means better future returns for a mutual fund scheme. The best way to have a lower expense ratio is to go for the direct plan of a mutual fund scheme. In 2012, Securities and Exchange Board of India (SEBI) asked asset management companies (AMCs) to introduce direct plans for all schemes. And from January 2013, every mutual fund has had two options: regular plan and direct plan. The same category, same scheme, same fund manager, same portfolio – the difference being the expense ratio charged to investors.

Direct plan has a lower expense ratio. These direct plans were created to connect investors directly to the mutual fund houses without any interference of intermediaries like brokers, distributors, advisors, and others. So, direct plans are those plans where investors can purchase units of MF schemes directly from the AMCs. They have lower expense ratio as the investors buy directly from the AMCs and hence do not have to pay any trail fees or commission to any broker or agent.

Therefore, the direct plan of a mutual fund scheme having a separate NAV is higher than a regular plan’s NAV.

This is because the operating expenses are directly deducted from AUM. The lower expense ratio of direct plans leads to lower deduction of expenses from the AUM, which translates into higher NAV than the NAVs of regular plans. For example, the average expense ratio of small-cap funds for a regular plan is 2.25 per cent and for a direct plan it is 0.84 per cent. What this means is that if you have invested Rs100 in the regular plan of a fund, on an average only Rs97.75 will be invested and in case of a direct plan Rs99.16 will be invested. In the long run it will help the fund to grow better than the regular plan.

We will try to understand the entire concept with the help of an example. One of the best performing small-cap funds, Axis Small-Cap Fund, was launched in the last month of 2013. Currently, at the end of April 2021, the difference between the expense ratio of direct plan of the fund and regular plan of the fund is 1.54. The expense ratio of the fund keeps on changing; however, it gives us a sense of how it has been. The current NAV of the direct plan is Rs51.06 whereas that of the regular plan is Rs46.58. So, in the last seven and a half years the difference in the return between those types of funds is 9.6 per cent and on an annualised basis someone invested in a direct plan would have gained 1.23 per cent without any difference in risk or anything else. 

The graph above shows the relative movement of the NAVs of regular and direct plans of Axis Small-Cap Fund.

The graph clearly shows how a direct plan is beneficial in the long run to an investor. So it makes perfect sense to switch from a regular to direct plan.

Making the Switch
Switching from regular to direct plan in many cases is considered as redemption. There are only few fund houses that treat it as normal switch and do not charge anything while in other cases it is considered as redemption and investment. The process and the expenses to be incurred during this switch will be the same as the ones incurred at the time of redemption of mutual funds. Many of the online transaction platforms provide such facility where you have to simply log-in, go to your fund and if it is a regular plan you can switch it to a direct plan. If your fund does not have an option to ‘switch from regular to direct plan’, you will have to select the ‘redeem funds’ option for the current scheme and then place a purchase order for the direct plan of the same scheme after the redeemed amount is credited to your account. In addition to the online mode you can also make the switch offline. In such a case you need to visit the branch of your mutual fund and fill the ‘switch’ form. 

Nonetheless, if no switch facility is available, you need to fill the redemption form and once the amount is credited to your account you can make a fresh purchase of the direct plan of the fund.

Cost of Switching
The process of switching from regular plan to direct plan involves redeeming your units from a regular plan and making a fresh investment into a direct plan. Therefore, this will involve all the costs incurred while redeeming your units i.e. exit load, if applicable, as well as tax. Different funds have different exit load but most of the funds do not charge anything if the redemption is done after one year of the purchase of the scheme. Therefore, if there are only a couple of months left to complete one year of your purchase of the scheme, you should better wait and make the switch after two months.

Another major cost involved is tax. Depending on the timeframe for which you have held the mutual fund, you will be subjected to tax either as short-term capital gain (STCG) or long-term capital gain (LTCG) if you are selling NAVs at higher price than the purchase NAV. Capital gains in the case of equity mutual fund units held for more than 12 months are considered as long term. STCG tax for equity funds is 15 per cent and for LTCG it is 10 per cent for gain in excess of Rs1 lakh. Debt mutual funds held for more than 36 months are considered as long term. The tax rate on STCG on debt funds is as per the income tax slab of the investor. LTCG will be taxed at 20 per cent with indexation benefit.

Apart from tax and exit load, another factor to look for while making a switch is the lock-in period. Locked-in units such as those of ELSS schemes prior to completion of the three-year lock-in period and closed-ended schemes cannot be switched from the current scheme to a new direct mutual fund unless the lock-in period of the scheme has ended. One of the reasons you invest is to get better returns and mutual fund is no exception. Therefore, if you can get better returns just by switching from regular to direct plan, it is better to make that switch. Nonetheless, you need to be aware of the cost involved and do a proper analysis before engaging in such an exercise.