Mutual fund investment: Index funds vs direct plans – Which is better?

Switch to a direct plan which has a lower expense ratio as compared to a regular plan or have a mix of index and actively managed funds to earn higher returns in the long-run

Investors should also look at direct plans, which have a lower total expense ratio as compared to regular plans.
Investors should also look at direct plans, which have a lower total expense ratio as compared to regular plans.

At a time when the one to three-year returns in most categories of equity mutual funds are negative and the five-year returns range between 3% and 5%, investors should restructure their portfolio to have a mix of index funds and actively managed funds. Investors should also look at direct plans, which have a lower total expense ratio as compared to regular plans.

Direct plans

In 2013, the Securities and Exchange Board of India instructed asset management companies (AMCs) to introduce direct plans so that investors can buy plans of a scheme directly from the mutual fund through online or through authorised branches. As there is no involvement of a distributor or an agent, the commission is saved by the fund house which will keep the expense ratio lower.

Experts say with rising awareness investors should opt for direct plans. However, in case one does not have any expertise or if the distributor does regular follow up on rebalancing, especially when the markets are volatile, then investors can continue with the regular plans. The Net Asset Value (NAV) of a direct plan is higher than a regular plan. So, the difference in the returns between a regular and a direct plan will grow if one stays invested long-term.

Brijesh Damodaran, managing partner, BellWether Advisors, says choosing a direct plan is recommended if you have expertise in investing and can manage the investment portfolio. “Direct plan definitely helps in reducing cost but what about the potential loss of returns, for action initiated in haste or own discretion? The direct plan should be considered when an investor is confident of his investments,” he says. The investor can switch to a direct plan by giving a Common Transaction Form to the registrar of the investor’s AMC. The investor can also use the online platform of the AMC to do the switch.

Sameer Kaul, CEO and MD of TrustPlutus Wealth Managers (India), says a switch from a regular to direct plan can be done by submitting a switch request form to the fund house or registrar and transfer agent. “Apart from the expense ratio, consider long-term performance and risk ratios of mutual funds schemes while selecting which scheme to invest in. Also, take into account the tax impact of switching to direct plans as from an income tax point of view, switching from a regular plan to a direct plan of even the same scheme is construed as a sale and purchase and has a tax impact,” he says.

Index funds
Another way to look at reducing expense ratio is to invest in index funds, which invest in stock market indices in the same shares and in the same proportion. As the expense ratio of index funds is lower (10 to 50 basis points) than other actively managed funds of asset management companies, returns generated can be higher in the long run.

Damodaran says index funds are slowly finding acceptance in India. Typically, it will replicate the index on which it is benchmarked and based. “It is passive investing and if one wants to replicate the returns of the index, then one should invest in it. While it has a lower expense ratio, that should not be the only reason to invest in index funds. The reason should always be the investing process and approach and the need,” he says.

Investors must always follow an asset allocation approach based on their risk tolerance level, says Kaul. “Any restructuring of the portfolio should be done keeping the overall asset allocation in mind. While the performance of mutual funds may not be encouraging in the short term, if one selects mutual funds based on their long-term risk adjusted performance, several funds are still outperforming the benchmarks over the long-term,” he says.

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First published on: 22-07-2020 at 08:00 IST