Difference between the expense ratio of direct vs regular mutual fund 

A mutual fund is an investment option that lets investors invest in different asset classes, such as equities, debt, and commodities. Every mutual fund has two investment plans: regular and direct plans. And the expense ratio of direct and regular mutual funds differs from one other.  

This article will focus on the difference in the expense ratio between direct and regular mutual funds and their impact. 

Before we talk about the difference in the expense ratio between these plans, let us know what these plans are. 

Direct and regular plans 

You must have noticed that the items are comparatively cheaper on the company’s online store than at a physical store like malls. It is because physical stores will need an incentive to sell their products, resulting in a higher price.   

A direct plan is what you get when you buy a mutual fund straight from the fund house. The direct plan is like purchasing things from the company’s online store. Purchasing a mutual fund via a distributor, on the other hand, is akin to buying items from a retail store.

Overall, the direct plan and regular plan are similar. The only difference between the two plans is their Total Expense Ratio (TER). 

Total Expense Ratio

The TER is a measure of the cost of managing a fund. It includes all the expenses that are associated with running a scheme. It includes administration costs, brokerages, and taxes associated with trading the scheme’s securities, fees paid to trustees, registrars and transfer agents, custodians, trustee personnel, legal and accounting fees, as well as sales and marketing expenses.

Fund houses calculate the expense ratio annually by dividing the fund’s operating expenses by the average value of the fund’s assets.

Assume there is a fund with ₹10 crore in assets under management. The fund house charges a management fee, an administrative fee, and other expenditures amounting to ₹10 lakh to manage the fund.

This fund’s overall expense ratio would be as follows:

Expense ratio = ₹10 lakh/₹10 crore = 1%

1% is the percentage of the fund’s total assets that must be paid out to run the fund.

Fund houses deduct this expense ratio from the investor’s invested amount. However, every fund house must adhere to the permissible expense ratio range. 

Difference between expense ratio of direct and regular plans 

Direct plans don’t have distributor commissions as a part of their expenses. So direct plans have a lower expense ratio than regular plans.

The TER difference between regular and direct plans varies between different schemes and fund houses. The difference in TER is due to the different commission structures of mutual funds. Commissions on equity funds, for example, are typically higher than commissions on debt funds, such as overnight funds and liquid funds. The difference in TERs between regular and direct plans might be anywhere from 0.5 to 1%.

Impact of the high expense ratio of regular plans 

Fund houses subtract the expense ratio from the returns when they give returns to their investors. If a regular plan’s total expense is 0.75% higher than that of the direct plan, the latter will give almost 1% higher return than the regular plan. Thus, it is evident that a higher expense ratio will mean lower returns.

The difference of up to 1% may not seem much initially. But, just like our investments compound over time, so do the expenses. In the long run, the amount of expenses would be staggering.     

To understand the impact, let us look at these examples.

Let us assume that two people invested in the same fund, invested the same amount of Rs.1 lakh and stayed invested for ten years. The only difference between the two is their choice of the investment plan. 

If we consider the difference in their cost is 1%, and the return in the direct plan is 15%*, then the return in the regular plan will be 14%.   

We can see that the person with the direct plan will accumulate ₹4.04 lakhs, while the one with the regular plan will get ₹3.70 lakhs. The difference between the two is almost ₹34,000. 

We have mentioned that costs also compound over time. Consider the case of two friends who started saving for their retirement when they were 25 years old. Both of them planned to invest in an equity mutual fund through a systematic investment plan. Let us assume for the sake of simplicity that they invested ₹10,000 per month till they turned 55.   

Here we can see that by investing just ₹36 lakh over 30 years, they could generate a corpus of 5 to 6 crores. But, if we see closely, we can see that the 1% difference has resulted in a difference of around ₹1.43 crore. Shocking, right?

But this is just a simple example. In life, most of us would increase the SIP amount regularly or invest lumpsum amount from time to time. So, the effect of the 1% difference will increase over the course of investment.

Conclusion 

Every fund comes with a regular and direct plan. The only difference is their expense ratio. We have seen in this article how a difference of 1% in return because of the high expense ratio of regular plans can result in a considerable difference in returns over a long period.