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How to switch from regular to direct funds?

Posted on 11 Dec 2021
Author: Sayan Sircar

Tags: Portfolio Review

8 mins read
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Investors who have investments in Regular mutual funds should switch to Direct. This post explains how.

How to switch from regular to direct funds?

📚 Topics covered:

Introduction
Step 1: Stop all SIP in Regular funds
Step 2: Use a platform that offers Direct plans
Step 3: Calculate the impact of taxes and switch smartly
- Method one: 1 lakh Equity LTCG exemption limit
- Method two: Loss harvesting
Step 4: Exit Regular plans first when rebalancing
Step 5: Single Switch
Step 6: Review your fund choices

Introduction

We start this article with two statistics:

Mutual fund distributors received around ₹5,500 crores of commissions from AMCs in FY 2020-21 as per AMFI data (source). This means that investors lost that wealth since it could have been a part of their portfolios.
For equity mutual funds, the average difference in returns between Regular and Direct plans in the last year is 1%. On average, the TER of a Direct fund is less than half that of Regular funds as per the latest MF scheme documents and reported by Valueresearchonline.

Investors who wish to learn more about Direct vs Regular mutual funds should read this article first: Do not make this mistake when investing in mutual funds.

The bottom line is: Regular plans have higher expenses or TER than Direct plans. This TER difference is the distributor commission that is currently 1% on average as per the statistics above. Therefore, the TER difference can become 25-30% over the investor’s working life. If you add the 30-40 years of lifespan post retirement, the difference becomes worse.

Gap of returns of Direct vs Regular funds

Investors should understand why they are losing money by investing in Regular funds and switch to Direct plans as soon as possible. A 25% difference in lifetime corpus value is between 7.5cr and 10cr as retirement corpus. So if you can manage retirement with 7.5cr, your distributor just needs three clients like you to manage their retirement. The investor has worked and invested for 30 years to reach this position under the guidance of the distributor, who ensured that he never switched away.

We discuss a few ways to switch from Regular to Direct plans for any investor. A Direct fund will have the word DIRECT in the name, and without the word DIRECT in the name, the fund is a Regular fund.

An exit from the Regular fund will involve selling units, leading to capital gains taxes. The impact of these taxes is one time. However, the lower returns in Regular funds will persist throughout the holding period. Since we are reducing expenses, we always prefer switching those units with the highest TER first.

Additionally, funds that declare dividends (IDCW plans) should also be avoided since dividends are taxed at the investor’s highest slab rate and reduce overall returns. Investors, therefore, should also switch from IDCW to Growth using the same methods described below.

Step 1: Stop all SIP in Regular funds

This step is the most obvious and ensures that no new money is entering the Regular plan. This step can be done online from the AMC website (log in using PAN and Folio number from account statement), CAMS, or Karvy websites. In the worst case, visit your nearest CAMS, Karvy office, to fill and submit a SIP cancellation form.

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Step 2: Use a platform that offers Direct plans

In order of preference, these would be:

AMC website
Registrar websites like CAMs and Karvy which allow transactions in all funds serviced by them
AMC owned portals like MF Utilities which supports almost all MFs in India
Direct plan portals: a simple Google search like “invest in direct funds in India” will bring out several such portals

Many of these platforms also offer Regular plans, so check that the fund name has the word Direct. Bank and stock brokers usually offer Regular plans. Please check the fund names before investing.

Step 3: Calculate the impact of taxes and switch smartly

As described in this post on how to calculate taxes and perform tax harvesting, we will see how we can exit with the least taxes to be paid.

Method one: 1 lakh Equity LTCG exemption limit

Profits on selling equity fund units purchased over one year are called long term capital gains (LTCG). LTCG is tax-free up to ₹1 lakh per financial year. Investors can wait until March to see how much equity LTCG they have accumulated over the year and, for the rest, sell just enough units from the Regular fund to reach up to 1 lakh in gains which is tax-free.

For example, you calculate on 10 March that you have sold 3 lakhs of equity MF till date in that financial year, which has led to ₹20,000 of LTCG. This means that you can sell additional units over a year old up to ₹80,000 of profits. So start with the Regular funds with the highest TER and sell enough units to reach up to ₹80,000 in profits. If you exceed the total of ₹100,000 in profits, you will have to pay 10% tax on the amount over a lakh.

Method two: Loss harvesting

Since losses can be offset against gains, if you have losses in some funds, you can sell them and offset that loss against profits in selling other funds. The tax rules say

Long term losses must be offset against only long term gains
Short term losses can be offset against both short and long term gains
As long you file returns every year, both short and long term excess losses can be carried forward for eight years

Since taxation rules may change every year, investors should check the current IT rules before doing anything.

Investors should be mindful of how much the tax is, as a percentage of the amount sold, relative to the TER difference. For example, if the tax is 5% and the TER difference is 1%, that is 5 years of TER, almost that is lost to taxes. In such a case, explore step 3 below.

Also read
Closet indexing: how to avoid funds that do this

Step 4: Exit Regular plans first when rebalancing

If the taxation is too much related to the TER difference, sell these funds first when rebalancing.

This post covers the details on how and why of rebalancing: Portfolio rebalancing during goal-based investing: why, when and how?

Step 5: Single Switch

Suppose you switch to the Direct plan of the same fund (XYZ Regular Plan to XYZ Direct Plan) or from equity to equity (or from debt to debt). In that case, you can do so in a single transaction. There is no need to time the market based on current levels since you move within the same asset class, either equity or debt.

If you are moving from equity to debt or vice versa, ensure that your asset allocation is appropriate for your goals post the switch. Read more here: What should be the Asset Allocation for your goals?. If you end up with a large amount due to switches, use this chance to fix your asset allocation for your goals.

Step 6: Review your fund choices

Suppose you have invested in high TER active funds. In that case, this is an excellent opportunity to switch to low TER active funds or simple index funds. This step not only reduces portfolio cost and simplifies portfolios, but the investor will also benefit from the impact of less active decision making in managing their portfolio. This point is made in more detail in the following posts:

Ultimately, the investor should understand the negative impact of distributor commission on their future portfolio values and make every effort to switch to Direct plans. The tax they will be paying today will be a minuscule percentage of the benefit to their portfolio over decades. Our official recommendation will be a one time switch from active equity funds to index funds. Investors requiring fund names to invest can benefit from the fund choosing methodology described in this post: Which funds should I invest in?.

If the investor needs advice on the choice of funds, they have the option of engaging with a SEBI Registered fee-only investment advisor for creating a complete financial plan including fund recommendations. However, if the Do-it-yourself (DIY) route is preferred, there are many online resources for educational purposes. For example, they can start here to educate themselves about the goal-based investing process.

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