How small things make a big difference in mutual fund investment

In a recent World Bank report on the ease of doing business, India for the first time has entered the club of top 100 business-friendly nations. One of the eight sub-categories where India has been ranked and performed better than other is in protecting minority interests. Under this sub-category, India is within top five worldwide. The credit for this goes to the pro-active market regulator, SEBI.

SEBI in the last few years has done a lot to promote and bring in transparency in the mutual fund industry. One such step was taken way back in 2009 when it abolished entry loads and made it mandatory for mutual fund distributors to disclose the fee that they earn from mutual funds and what they charge their customers directly. The rationale behind this move was that customers should know and pay for the services in terms of advice being given by distributors. Nevertheless, not many MF distributors are charging directly to investors. If that is the case then how do they earn?

According to a report by Association of Mutual Funds of India (AMFI), top 10 distributors, based on commissions received in FY17, got Rs. 2,379.42 crore in commissions in 2016-17, compared to Rs. 1,725.67 crore that they got in 2015-16, a rise of almost 38  per cent on yearly basis. The source of such income for MF distributors is upfront commission and trail commission that they receive from fund houses for the business that they have generated for them.

An upfront commission is paid to MF distributor in the same month when the business has been generated for fund houses. Whereas trail commission is paid at the end of every year as long as you remain invested in their funds.

Equity schemes normally charge more than 2  per cent  in terms of expense ratio every year to their unitholders. However, the limit is 2.75  per cent  for equity schemes and 2.5  per cent  for debt funds. Say for example your equity fund has an expense ratio of 2.25  per cent . Out of this 0.25  per cent  goes for custody charges to the registrar and transfer agents like CAMS and Karvy. Out of the remaining 2.00  per   cent  fund house pays an upfront commission of say 0.5  per cent  to the distributor and 0.25  per cent  as trail commission. Rest 1.25  per cent remains in fund house kitty. This commission structure is also applicable to Systematic Investment Plan (SIP) but with certain tweaks as investment amount remains low.

Industry average of an upfront commission is in the range of 0.75-1.00  per cent  and 0.5  per cent  as trail fees. This is higher for distributors operating from beyond top 15 cities (B-15). These cities are defined as smaller cities by AMFI due to the lower generation of MF business from these cities.

This is how MF distributors earn their income. Nonetheless, if you have invested in funds directly without involving any distributor (including your bank), most of these commissions are not charged to you and is reflected in the lower expense ratio of the direct plan. For example, HDFC Equity Fund’s direct plan has an expense ratio of 1.17  per cent  at the end of September 2017, while for the regular plan (investment routed through a broker) expense ratio is 2.04  per cent .

This small difference makes a big impact for a long-term investor as your NAV is calculated after deducting these expense ratios. Hence the difference between the return of a regular plan and direct plan is around 1  per cent  for a year. Therefore, if you are an investor and know which funds to invest in, we advise you to go for a direct plan for better returns.