What if a lawyer offers to fight a case on your behalf for free, would you take it? If the answer is no, why would you accept the same offer from a mutual fund advisory? The answer is not simple. To understand the basic difference between direct mutual funds and regular mutual funds, you will have to understand what happens behind your eyes. The vast majority of retail investors are completely unaware of how the distribution/brokerage model works. In this article, I will explain it to you in detail so that you can be the judge and decide which one is better for you.
How the mutual fund industry works: Asset management companies (AMCs)/ mutual fund companies have expensive setup and operating costs. Their business is only viable if done on a mass scale as they earn only a few basis points of the total expense ratio. Most asset management companies don't have a distribution reach beyond their immediate circle of influence (Their business connections, friends, relatives, relatives of stakeholders, strategic alliances etc.). Also, it is not feasible to hire a very large sales team. Hence, they all rely on external sources to help get new investors' money into their mutual funds and increase the assets under management. The external sources who help increase the total investor base and amount are known as distributors. These distributors (aka mutual fund advisors) are responsible to convince investors to invest in a particular mutual fund scheme. They don't charge the investor any fees for their services because they are getting a commission from the fund houses directly. Essentially what happens is that the fund house charges an annual management fee which is <2.5% of the total investment amount on a yearly basis. Out of this, approximately 1 to 1.8% is given to the distributor as a commission on a yearly basis (paid monthly), for as long as the investors remain invested with the mutual fund. Any incremental investment into the same fund will also entail a commission to the distributor regardless of whether or not they helped you in any way. For example, if you invested Rs 5,00,000 in a mutual fund on the advice of someone who hasn't charged you a fee, that person/agency will earn approximately between Rs 5000 to Rs 9000 from you on a yearly basis.
The icing on the cake for the distributor is that as your investment amount appreciates, the percentage based commission will be paid on the latest investment value and not on the initial amount of investment. For example, if your Rs 5,00,000 investment has gone up to say Rs 10,00,000, the distributors' commission will now be between Rs 10,000 to Rs 18,000 per year in trail commissions. This effectively reduces the investors' return to that extent. Because of this kind of incentive system, distributors will almost always choose to sell those funds which give the highest commissions since their income depends on it. From a broad perspective, it has been a win-win situation for everyone involved because the asset management companies managed to perform well and in many cases outperform the markets.
Who are these distributors: There are various types. The largest distributors of regular mutual funds are the banks and the national/regional wealth management firms. They have a sizeable market share in this business as they have a vast reach through their extensive branch networks across the country. Their reach allows them to get new investors. Apart from that, the Independent Financial Advisors (IFAs) are individuals, small firms that advise people to invest in mutual funds. Although they are small in size, there are over 85,000 IFAs that employ over 1,70,000 people who are on selling mutual funds across India's Tier 1 and 2 cities.
How things are changing: However, there is a sense of awakening now as the regulator realises that many distributors have been misselling funds and their income stream represents a conflict of interest because they are likely to act in favor of the fund houses rather than the investors because they get paid by them. To change the scenario, SEBI is trying to make the market more transparent by mandating additional disclosures to be made public on a half-yearly basis about how much the mutual fund distributor earns in absolute terms. There is now a mechanism that allows investors to directly invest in mutual funds at the click of a button, just like stocks. These platforms can offer direct/regular funds depending on their business model. Platforms which offer regular funds don't charge the customers directly whereas those that offer direct funds charge a nominal platform fee.
Main differences between direct mutual funds vs regular mutual funds and platforms that offer them:
==Direct mutual funds have a lower expense ratio than regular funds because the fund house doesn't need to pay the distributors any commissions.
==Direct mutual funds give higher returns because investors save about 1 to 1.8% per year as there is no intermediary.
==Direct mutual fund execution platforms have fixed fees per year regardless of the size of your investment. Although regular mutual fund platforms don't charge, they earn much more indirectly.
==Direct mutual fund platforms charge separately for advice which can be discretionary whereas regular mutual funds don't charge you anything for advice.
In general, people have a reluctance to pay a recurring fee for investment services which is why direct mutual funds are not very popular as yet. In the larger scheme of things, what really matters is the quality of advice being given and the net returns you make as a result of the advice. If you're not looking for advice, then going direct makes the most sense. Make your investment decision after factoring in the above information.(The writer is CEO and Co-Founder FYERS)