Direct Plan and Regular Plan: The Cost and the Trade

A direct plan and a regular plan are two versions of one scheme holding exactly the same portfolio, run by the same manager, and differing only in expense ratio. Here that is 0.85 per cent against 1.65 per cent. The extra 0.80 percentage points a year buys advice and service from a distributor. The arithmetic of that gap can be settled exactly. Whether the service is worth it to a particular holder cannot.

Here is what sits underneath that. A planA version of one scheme with its own expense ratio, and therefore its own unit value. is not a fund. A plan is a version of one fund, sold on different terms, and the securities inside it are the securities of the fund. So when two plans of one scheme carry two different expense ratiosThe yearly charge on a scheme, said as a percentage of what the scheme holds., nothing inside the scheme has changed. Only the charge has. Every figure below follows from that single structural fact: one portfolio, two charges.

Three facts stand behind the comparison. The difference between two plans of one scheme is the distribution componentThe part of a scheme charge that pays a distributor for advice and service., the part of the charge that pays a distributor. A gap of 0.80 percentage points a year compounds, so it is worked as 1.008 raised to the number of years held rather than multiplied out. And the ratio is taken from the scheme's assets a little at a time every day rather than billed to anybody. No holder has ever seen this charge as a line on a statement.

One scheme runs through this guide from end to end. Girnar Asset Management Limited, an invented asset manager, runs the Girnar Large Cap Equity Fund, an open ended equity scheme with net assets of Rs 42,00,00,00,000/- and 120.00 crore units outstanding. Those two figures divide to a value of Rs 35.00 a unit. The scheme has 3,80,000 folios, so the average folio holds about Rs 1,10,526/-. Kalyani Bhagat is the fund manager. Sohail Merchant heads operations. The scheme is sold in two plans, one carrying 0.85 per cent and one carrying 1.65 per cent.

What is a direct plan of a mutual fund scheme?

A direct planA version of a scheme whose expense ratio carries no distribution component. is a version of a scheme whose expense ratio carries no distribution component. The holder comes to the scheme without a distributor in between, so the scheme is not paying anybody for advice or for service to that holder, so no part of the charge is set aside for it. In the Girnar Large Cap Equity Fund the direct plan carries 0.85 per cent a year, taken from the scheme's assets a little each day. A direct plan is a full version of the scheme, with the whole portfolio behind it, and the word direct describes the route in rather than the contents.

Think about the vegetable seller two lanes from a household's door and the same vegetables delivered to the door. The carrot is the carrot. The difference is that in one case somebody has walked, chosen, carried and knocked, and in the other the household has done the walking itself. Nobody would say the delivered carrot is a different vegetable. A direct plan is the walk taken by the holder.

What is a regular plan of a mutual fund scheme?

A regular planA version of the same scheme whose expense ratio includes a distribution component. is a version of a scheme whose expense ratio includes a distribution component. The distribution component pays a distributor for advice and service to the holder. The holder comes to the scheme through that distributor, the distributor is paid out of the charge rather than by a separate bill, and so the ratio on that version of the scheme is higher. In the Girnar Large Cap Equity Fund the regular plan carries 1.65 per cent a year, taken from the same assets in the same daily way. A regular plan is also a full version of the scheme, with the whole portfolio behind it, and the higher charge buys service rather than a different set of securities.

What is identical between the two plans?

More than most readers expect, and this is the part worth slowing down on. In the Girnar Large Cap Equity Fund the two plans hold the same securities. Both hold them in the same weights. Kalyani Bhagat selects them once, for the scheme, not twice. Every decision taken inside the scheme, every purchase, every sale and every day of waiting, happens once and reaches both plans. The method by which the unit value is computed each day is the same method. The difference between the two plans is not a different investment. Anybody who reads a direct plan as holding something different from a regular plan has misread the structure rather than the cost.

Two people buy the identical steel almirah from the identical shop on the identical day. One of them paid a man to measure the room first, argue about the price and get it up three flights of stairs. The almirah is the same almirah. Nobody would look at the second one and say it holds different clothes. The difference sits entirely outside the object, in the service that surrounded getting it there, and pricing that service honestly is the whole of the difficulty.

What is different between the two plans, and by exactly how much?

One number, and it is the expense ratio. In the Girnar Large Cap Equity Fund the direct plan carries 0.85 per cent a year and the regular plan carries 1.65 per cent a year. Subtract one from the other and the difference is 0.80. The unit of that 0.80 is where a lot of confusion starts. The difference between two percentages is measured in percentage pointsThe unit for a difference between two percentages, so 1.65 less 0.85 is 0.80 percentage points., not in per cent. The regular plan is 0.80 percentage points a year more expensive. Since 1.65 divided by 0.85 is about 1.94, the regular plan is also about 94 per cent more expensive. Both sentences are true and they are describing the charge against two different basesThe value a percentage is measured against, without which the percentage states nothing..

There is a second difference, and it is a consequence of the first rather than a separate decision. Because each plan accrues its own charge against the scheme's assets every day, the two plans do not carry the same unit value. The plan charging less gives up less each day, so its value per unit runs ahead. The record states one value of Rs 35.00 a unit for the Girnar Large Cap Equity Fund and does not split that value by plan, so the divergence appears as an index from a common start rather than as a second unit value. That is not a technicality. A fabricated second value standing in for a missing one would be worse than the gap it fills.

What does the gap come to across a holding period?

Across a long holding period 0.80 stops sounding like a rounding argument. The gap is not paid once. The gap is given up every year, on a balance that has itself been reduced by the years before, so it compounds rather than adds. The arithmetic is the compounding arithmetic already derived and no other: 1.008 raised to the number of years the units are actually held. Nothing else is modelled, no return is assumed for either plan, and the figure that comes out is the ratio between the two plans rather than anything either plan produced.

Raised to five, 1.008 gives 1.040645. To ten, 1.082942. To twenty, 1.172764. Read as a percentage that is a gap of about 4.1 per cent at five years, 8.3 at ten and 17.3 at twenty. Across the second decade the gap adds slightly more than it added across the first, so the twenty year figure is a little over twice the ten year figure rather than exactly twice it, and the curvature at this size of charge is real but gentle. The striking thing about the twenty year number is its level, not its bend.

Now the part that trips people. The 17.3 per cent has a base, and the base is the regular plan. Set the regular plan value at 100 and the direct plan stands at 117.276, or 17.3 per cent more. Turn it around and measure from the direct plan instead: one divided by 1.172764 is 0.8527, so the regular plan holds 14.7 per cent less than the direct plan. Both readings are correct, they describe the identical gap, and neither of them is a figure at all until somebody says which value it is measured against. A figure quoted without its base is half a number.

Read the last two columns across, not down. Every row shows the same gap twice, once against each plan, and the two numbers in a row never match because the two bases never match. The index column is how a divergence is shown when the record holds only one unit value: the regular plan is pinned at 100 for every year and the direct plan is drawn against it, so no return is claimed for either plan and no second unit value has to be made up.

What does the extra 0.80 percentage points a year buy?

The extra 0.80 percentage points buys a service, and the service has parts that can be named. The charge buys advice on what to do and when, from somebody who has looked at the case. The charge buys a person who handles a transaction the holder would otherwise handle alone, including the paperwork that goes wrong, the folio that will not open and the request that has to be chased. The charge buys somebody to call when circumstances change. For most households that is the year a job ends, a house is bought or a parent falls ill. And the charge buys continuity, meaning the same person is still there in year seven and still remembers what was decided in year two.

A service is being purchased, a holder who bought it has not made a mistake, and the arithmetic above says nothing against that. The arithmetic prices one thing and one thing only: the charge. The arithmetic does not price the service, does not measure whether the service was delivered, and is not evidence about either. A compounded cost figure set out with nothing said about what the money was for makes an argument it has not earned.

Which plan should a reader hold, and why is that question not answered here?

Here is the whole shape of the question. One side of this trade is a number. On every Rs 1,00,000/- held, the extra 0.80 percentage points a year is Rs 800/- a year, or about Rs 67/- a month. On the average folio in the Girnar Large Cap Equity Fund, Rs 1,10,526/-, the charge is about Rs 884/- a year, or about Rs 74/- a month. Every one of those figures follows from the ratio alone.

The other side of the trade is the value of the advice and service to that particular holder. No record holds that value, and none could. The value depends on what the holder actually receives, what they would otherwise have to do themselves, what their own time is worth to them and what the same help would cost bought separately. The value differs for every holder and for every distributor. Resolving a trade while one of its two sides is missing produces advice rather than arithmetic.

So the comparison stops here, and the stopping point is itself the finding. Break-evenThe point at which the value of what is bought equals the charge paid for it. is the honest way to present a trade with one side unknown: state the point at which the two sides are equal, and leave the reader to place themselves against it using facts about their own case that no document can see.

Break-even also moves with the amount held. At 0.80 percentage points a year, a holding of Rs 1,00,000/- carries an extra Rs 800/- a year, a holding of Rs 3,00,000/- carries Rs 2,400/- and the average folio of Rs 1,10,526/- carries about Rs 884/-. The charge scales exactly with the amount held. The service being bought very often does not. The same trade can therefore look completely different to two households paying the same distributor. Two people receiving an identical hour of the same person's attention are paying different amounts for it if their holdings differ, and that is a fact about the pricing structure rather than a criticism of anybody in it.

Leave the control where it starts and the two bars are level at Rs 800/- a year, about Rs 67/- a month, or about Rs 884/- a year and Rs 74/- a month on the average folio of Rs 1,10,526/-. Level is break-even, and it is the only neutral setting available. A default of zero would assert that the service is worth nothing to anybody, and a high default would assert the opposite. Move the control and one bar passes the other. Notice that no setting of the control says which bar ought to be taller, and none can: nothing outside the holder's own case settles it.

What does all of this look like on one scheme, end to end?

Here is the whole thing on the Girnar Large Cap Equity Fund in one order, and the order is the argument. Start with what is identical: same securities, same weights, same manager in Kalyani Bhagat, same decisions, same daily valuation method. Then the single difference: 0.80 percentage points a year, being 1.65 per cent against 0.85 per cent. Then the year one figure on the average folio of Rs 1,10,526/-, about Rs 884/- a year or about Rs 74/- a month. Then the same gap compounded across a holding periodHow long the units are actually held, which decides what the annual gap compounds to.: 1.008 raised to five is 1.040645, to ten is 1.082942, to twenty is 1.172764, giving about 4.1, 8.3 and 17.3 per cent against the regular plan ending value and about 14.7 per cent at twenty years against the direct plan ending value.

One more line of arithmetic makes the scale visible, and it is a supposition rather than a fact about this scheme. The Girnar Large Cap Equity Fund holds net assets of Rs 42,00,00,00,000/-. If every rupee of that sat in the plan carrying the higher ratio, the 0.80 point difference would come to Rs 33,60,00,000/- a year, or Rs 33.60 crore. The scheme assets are not split between the two plans anywhere in the record, so the crore figure rests on an assumption rather than on anything the Girnar Large Cap Equity Fund reports. The same 0.80 points is both about Rs 74/- a month to one household and a large number at the scale of a scheme.

The left side of the break-even comparison can be computed and the right side cannot, and the right side is not a number anybody can look up. A reader who concludes the service is worth more than the charge to them and a reader who concludes it is worth less have both used the arithmetic correctly. The trade is left unresolved, and leaving it unresolved is the finding. John C. Bogle argued in Common Sense on Mutual Funds, published in 1999, that cost is the part of a holder outcome that is known in advance while the rest is not, and that proposition is why the left side of this comparison can be computed at all.

What would a reader need to know to answer it for themselves?

Four questions, and they are questions rather than tests. First, what is the service in the particular case, named specifically rather than in general: what does the person actually do for the holder. Second, is it in fact received. Being described and being received are different things. Third, what would the same help cost if bought separately and directly, a price that can be found out. Fourth, how long is the holding expected to last. What the annual gap compounds to depends on that and on nothing else.

A reader who answers those four honestly may reasonably land on either plan, and both landings are correct uses of the arithmetic. Two people can answer them in good faith, reach opposite conclusions, and both be reasoning well. The four questions are about their own circumstances rather than about the scheme. Whether any particular sale was suitable in the first place, and whether the service that was paid for was actually delivered, are conduct questions and are covered separately under wealth and advice.

How does anybody actually use this on a working day?

A person at a service desk answers one question more often than any other: why two versions of one scheme show two different values per unit. The answer is short: the two plans accrue different charges every day against the same portfolio, so they diverge, and nothing inside the scheme is different. Saying that clearly in thirty seconds is most of the job, and saying it without implying the holder did something foolish is the rest of it.

An analyst comparing two published records uses it as a warning about bases. A scheme return is a net figure and carries its own plan charge inside it, so comparing the published record of a direct plan with the published record of a regular plan of the same scheme is comparing two figures that differ by construction rather than by anything the manager did. The like for like comparison is a plan against the same plan, and any comparison that crosses plans has to say so.

A household with a long horizon uses it as an arithmetic check on itself. Take the amount held, take 0.80 per cent of it, divide by twelve, and the monthly figure appears. The next question is what a month of the service delivers for that. The whole discipline is converting a percentage into units a person can actually weigh: rupees a month against a service that can be named. Rs 74/- a month is a figure a household can think about honestly. 0.80 per cent is not. Nobody has ever felt 0.80 per cent of anything.

Girnar Asset Management Limited, the Girnar Large Cap Equity Fund, the Girnar Broad Market Index Fund, Kalyani Bhagat and Sohail Merchant are invented.
Educational material. Not advice on any investment, tax, budget or market position.