Investments in mutual funds do not end with merely selecting the right scheme. Often, seasoned investors focus more on costs to maximise returns. This is one of the effective ways to generate incremental returns and help create a large corpus for investors.
One way to reduce your cost of investing in mutual funds is to invest in direct plans of mutual funds. This calls for switching from regular mutual fund schemes to direct mutual funds. Let us first understand the difference between regular and direct plans of mutual fund schemes.
What is a regular mutual fund scheme?
Regular mutual fund schemes are sold by mutual fund distributors. These plans include the cost of commission payable to distributors. Since January 2013, on the instruction of the capital market regulator - Securities & Exchange Board of India (SEBI), mutual fund houses launched direct mutual fund plans.
What is a direct mutual fund scheme?
Direct schemes are meant for those investors who do not want to channelise their investments through distributors. Direct plan of a mutual fund scheme does not account for commission payable and hence it entails lower charges. This means that the expense ratio of a direct scheme is lower than that of a regular plan of a mutual fund scheme.
The difference between the expense ratio of a direct and regular plan of an equity fund can be as high as 1 percent. With all factors remaining the same– the fund manager, the portfolio and the terms of investments— it is thus a lucrative option to opt for direct plans and boost returns in the long-term. However, for investors who lack the skill or time to manage their mutual fund investments, the regular plan of a mutual fund is a more suitable option.
How do you switch to a direct plan?
There are many mutual fund transaction platforms which allow you to invest in direct plans of mutual fund schemes. You can also apply through websites of mutual fund houses and Registrar & Transfer Agents. An MF Utility portal can also be used for the same.
Factors to consider while switching from regular mutual funds to direct mutual funds
A switch from one plan of a mutual fund scheme to another is considered as the sale of a mutual fund unit. It will attract capital gains tax and exit loads, wherever applicable.
Taxation
Gains on sale of units in equity funds held for more than one year are treated as long term capital gains. If such gains exceed Rs 1 lakh in a financial year, it attracts 10 percent tax. Otherwise, gains on equity funds are taxed as short-term capital gains and taxed at 15 percent.
In case of bond funds, gains from the sale of units held for more than three years are treated as long-term capital gains and taxed at 20 percent after indexation. Otherwise, gains in bond funds are taxed as short term capital gains according to the tax slab rate of investors.
Since any switch is considered a sale of units, capital gains tax is payable. Thus, when an investor decides to move from a regular plan to direct plan, she should ascertain capital gains tax liability and time the exit properly.
For relatively small investors holding units of well-managed schemes, capital gains taxes can be planned by timing the switch of units in such a manner that in a given financial year capital gains on equity funds are kept below the Rs 1 lakh threshold.
In case of bond funds, selling in April could be more beneficial than exiting the investment in March. This is because such a transaction would provide indexation benefits for the year of sale, increase indexed cost of acquisition and thus, reduce the tax liability of an investor. Let us understand this point with an example.
Assume an investment was made on June 1, 2015. And a switch was made in March 2021. In this case, the investor is eligible for indexation benefit using cost inflation index numbers for six years. However, if she waits for one more month and sells in April 2021, she can then claim indexation benefit for one more year since the sale took place in the new financial year.
Exit loads
If you have invested in units of a mutual fund scheme in the recent past then exit loads may be charged. An investor is charged an exit load if she decides to exit the investment before a time-frame decided by the mutual fund scheme. It is better to check if a switch from regular to direct plan attracts exit loads. Some investors prefer to remain invested till the exit load period gets over to avoid the extra charge.
Underperformance
Not all mutual fund investments give good returns. Sometimes mutual fund schemes do not perform as expected. Such underperformers need to be weeded out of the portfolio. It is better to conduct a review before you switch from regular plan to direct. At the review stage such investments in units of underperforming schemes can be identified and sold. This reduces unnecessary efforts of shifting schemes from one plan to another. Also if you decide to sell units in an underperforming scheme after switching to direct plan, then you have to wait for some time as there is a provision of exit load in most of the equity schemes.
So, these are the primary factors you need to consider before switching to direct plans. However, do consider checking the asset allocation in your portfolio in the context of your financial goals and your risk appetite before initiating a switch from a regular to a direct plan. All of this should help you make the most of switching to direct plans.