If you have been reading our content for a while, you would have noticed we have a strict no policy for regular mutual funds. Let’s discuss why we hate regular mutual funds and why you should too.
Estimated read time: 3 minutes and 50 seconds
Hint: After knowing the truth, buying a regular fund will feel like punching yourself.
Buckle up, here we go!
Everyone has told you to invest in stocks/equity. They have recommended mutual funds if you don’t have enough knowledge or time to pick individual stocks. The portfolio diversification benefit is a plus.
Why invest in a mutual fund in the first place?
You would have heard to avoid keeping all your eggs in one basket, right? Mutual funds are built on this principle.
If you invest in a single company, your risk is high because if the company fails, your money is gone.
So what do you do? You think to invest in some more companies to diversify your risk. But wait, you don’t have enough knowledge to identify different companies from different industries? Or you don’t have enough time to do the research and manage your investments, right?
Don’t worry, the mutual fund companies (AMC – Asset Management Company) have got you covered. Let’s say a buddy with excellent knowledge steps up and says he will do the research for you and invest for you. He will manage the money you give him – Manager.
So, you give him your money to invest, and in exchange for his service, he collects a small fee.
Now, let’s dig deeper.
Over time, this manager guy builds more funds based on the investment style – some are riskier than others and give you more choices. You can invest in any fund based on your risk appetite.
The small fee he collects is an expense ratio – calculated on the total fund managed. For example, if a manager handles ₹1 crore and collects ₹1 lakh as his fees, the expense ratio is 1%.
Now, the mutual fund industry has developed a lot, so they don’t have a single manager handling the funds. They have a huge team to manage the funds and provide you with good returns on your investment. They distribute the collected fees among their team.
Till now, with us?
Difference between a direct and regular mutual fund?
We spoke about how you give your money to a manager. It is easy if you know this manager already or heard about him, right?
But what if you have never heard about him? How will you find this guy and give your money to him to manage?
Here comes a distribution company aka sales guy. So this sales guy has a deal with the manager. They bring him clients, and he will pay them a small fee.
How will our manager pay for this sales guy? If you invest in the mutual fund through this sales guy, the manager will charge you extra, aka an added commission.
If you had found the manager and invested directly, your expense ratio would have been 1%. That is a direct mutual fund.
But, since you invested through a sales guy – distribution company, your expense ratio is ~1.5%. Yes, you pay extra every year. That is a regular mutual fund.
How do the mutual fund companies collect the fee?
Management’s fee is automatically collected every year from the funds you provide them to manage. So this changes the return rate you receive from your investments because the expense ratio is already subtracted.
For example, let’s say last year, the mutual fund performed well by growing its investments by 15%. At the year-end, they will take out money for their expenses.
If the expense ratio of a direct fund is 1% then your returns for the year are 14%. And if the expense ratio of a regular fund is 1.5% then your returns for the year are 13.5%.
Does this minor difference in returns matter?
Yes, the minor difference in returns may not seem significant in the short term but make an enormous difference in the long term. Let’s understand this with some math because numbers never lie.
Say you have ₹10 lakhs to invest. Since you don’t have enough knowledge or time, you contact a sales guy – distributor. He helps you find the best regular mutual fund and helps you invest your money. In exchange, he doesn’t charge you because he receives a commission from the mutual fund company, AMC.
The regular mutual fund’s expense ratio is 1.5%. Assuming the fund provides 12% returns for the next 10 years. After deducting the expense, your ₹10 lakhs investment has grown to ~₹27.1 lakhs.
But what if you spent some time educating yourself and investing in a direct fund? In 10 years, your ₹10 lakhs investment will grow to ~₹28.4 lakhs!!! Amazing right?
The difference in expense ratio will cost you ₹1.3 lakhs for an investment of ₹10 lakhs. If you invest more and for a longer time, this difference grows. Can you afford to lose that much in commissions? Or was the sales guy’s advice worth lakhs of rupees?
Think about it. Hope you understand why we always recommend investing in direct funds. You shouldn’t be paying lakhs in commission, whereas that money can do a lot more good for you and your family.
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If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
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