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Mutual funds: Why direct plans are stealing the show

Sebi data shows direct plans outperform benchmark, give better returns than regular ones. (Mint)
Sebi data shows direct plans outperform benchmark, give better returns than regular ones. (Mint)

Summary

Investors who already have investments in a regular mutual fund plan should note that their decision to shift to a direct plan is bound to have tax implications.

Should you shift your mutual fund investments from a regular to a direct plan? This is the question that many investors currently grappling with, especially after the market regulator, Securities and Exchange Board of India (Sebi), came out with data recently that showed direct plans beating regular ones across multiple time frames.

The Sebi report said that 66% of direct funds outperformed their benchmark over a 10-year period, whereas only 39% of regular funds managed to do so. Over a five-year period, 45% of the direct mutual funds beat their benchmark, while 26% of regular mutual funds outperformed the benchmark.

For starters, a regular mutual fund plan is sold through a distributor, whereas a direct plan is bought directly by the investor from an asset management company (AMC). This means that regular plans charge a higher expense ratio since AMCs have to pay a commission to distributors. Investors opting for the direct route can avoid this commission amount paid by regular plan investors. Experts say that this has a big impact on investment returns over a period of time due to the nature of compounding.

As per research done by SahajMoney, a Sebi registered investment adviser, an individual investing in mutual funds through a direct plan will generate 25% more returns over a 30-year period than by investing through a regular plan. This calculation assumes a 10% compounded annual growth rate for both plans, 2% expense ratio for the regular plan, and a 1% expense ratio for the direct plan.

 

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Direct plans are useful for two kinds of investors. Firstly, it makes sense for those with adequate financial knowledge to choose investments based on their own research and hence don’t need a distributor to hand-hold or guide them. Secondly, there are people who use the services of a fee-based registered investment adviser. These advisers charge a fee—either a fixed fee or a percentage of the total assets—for advising their clients but are not allowed to earn commission income. Since they are already paying a fee, it makes sense for such investors then to take the direct route for investing in mutual funds.

Investors who already have investments in a regular mutual fund plan should note that their decision to shift to a direct plan is bound to have tax implications. This is because such investors have to first sell their existing mutual fund units before shifting to a direct plan and need to pay capital gains tax. Not just that, some mutual funds also charge an exit load which is deducted during redemption.

Suresh Sadagopan, principal officer of Ladder7 Wealth, said the decision to switch from a regular plan to a direct plan should be taken carefully as it will have a tax impact. He said the decision to redeem your investments now would attract capital gains tax and that amount would lose out on the compounding that could have happened if there was no exit in the first place.

In the case of equity mutual funds, the government levies a capital gains tax of 10% for investment held for more than a year and a short term capital gains tax of 15% for investments held for less than 12 months. For instance, let’s say you invested 10 lakh over a five-year period in a regular plan and the current value of the investment is 18 lakh. This implies a profit of 8 lakh and you are liable to pay taxes on the profit during redemption. Now, since the investment horizon was more than one year, you have to pay a 10% long-term capital gains tax on the gains made. This comes to around 80,000. That is the cost you have to bear while converting from a regular to a direct plan.

When you opt for a direct plan, you would be reinvesting a lower amount, say 17.2 lakh in this case, since you have paid 80,000 as taxes. However, if you continue with the regular plan at this juncture, the original amount continues to compound.

According to a calculation by Mint, assuming the investments compound at a 12% rate annually, and the expense ratio of regular and direct plans is 2% and 1%, respectively, it would take roughly six years for the direct plan to start beating the regular plan. Note that this six-year lag is due to the switching cost incurred while shifting from a regular to a direct plan.

Another point to consider is that the gains are not taxed if it is less than 1 lakh. This means you do not have to pay any capital gains tax if your gains are less than 1 lakh in a year.

In that case, you can redeem your investment without incurring any capital gains tax. Also, gains made before 31 January 2018 are not eligible for capital gains tax since the decision to tax capital gains on equity mutual funds was taken only after that date.

Dev Ashish, founder of Stable Investor, a Sebi registered investment adviser, said those who have accumulated large capital gains can exit regular funds in a phased manner. This can be done so that they redeem only up to 1 lakh of capital gains per year, which is tax-exempt. He also said that investors can also look to exit regular funds when the markets are down as that would otherwise reduce the gains made on the principal amount.

On the other hand, switching over from a regular debt mutual fund plan to a direct plan might need some more consideration as they attract a higher capital gains tax compared to equity funds. Debt funds bought after 1 April 2023 would be taxed as per the tax slab of the individual investor. To be sure, debt mutual fund investments prior to 1 April enjoyed a tax advantage of 20% including indexation benefit for investments held for more than three years.

According to a calculation by Mint, if you decide to switch from a regular to a direct plan of a debt mutual fund (assuming that you have invested after 1 April 2023), it will take roughly 20 years for the direct funds to start beating the earlier-held regular funds. This is assuming that you invested 10 lakh and the current value of the investment is worth 14 lakh and you paid a 30% tax on the capital gains amount of 4 lakh. In the case of debt mutual funds also, tax is exempt on gains of up to 1 lakh.

Harshad Chetanwala, co-founder of MyWealthgrowth, said many people simply invest based on a fund’s past performance which can lead to a risky allocation in the portfolio. He recommends going through a distributor if the investor is not well-versed in finance as good distributors will provide basic guidance.

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