Hidden Costs Can Cut Up to 25% of Mutual Fund Returns Over Time, Study Warns

Indian investors are often advised that patience, discipline, and long-term investing are the cornerstones of wealth creation. While these principles remain valid, a recent study suggests that for a large section of mutual fund investors, a hidden structural cost is steadily eroding returns — even when investment discipline is maintained.

According to a study conducted by 1 Finance Research, more than 80% of equity mutual fund schemes leave investors in regular plans at least 25% worse off than those invested in the direct plans of the same schemes over a 10-year holding period. Alarmingly, in nearly one-fifth of the schemes analysed, the difference in accumulated wealth exceeds 50%, despite identical portfolios and market exposure.

The key driver behind this widening gap is not market performance or poor fund selection, but the compounding impact of higher expenses embedded in regular plans.

Regular and direct mutual fund plans invest in the same underlying assets and are managed by the same fund managers. However, regular plans include distributor commissions within their total expense ratio (TER), while direct plans exclude these costs. Although the annual difference in expense ratios often appears small — sometimes less than one percentage point — its long-term impact can be substantial.

To isolate the effect of costs alone, the study analysed AMFI NAV data for Direct Growth and Regular Growth equity schemes across categories. A uniform Rs 100 investment was assumed from the same start date for both plan types, ensuring that the only differentiating factor was cost. The results showed that the wealth gap widens steadily with time and accelerates due to compounding.

Over shorter investment horizons, the erosion may appear manageable. Over a five-year period, around 53% of schemes saw regular plan investors lose at least 15% of potential wealth compared with direct plan investors. However, extending the holding period to ten years transforms moderate underperformance into significant capital erosion.

Ironically, data indicates that investors in regular plans tend to stay invested longer. As of March 2024, over 21% of regular plan investments were held for more than five years, compared with less than 8% for direct plans. While longer holding periods should amplify compounding benefits, higher recurring costs steadily dilute returns instead.

Experts involved in the study highlight that this erosion is structural rather than market-driven. Expense ratios reduce returns every single year, regardless of whether markets rise or fall. Unlike volatility, which can work in an investor’s favour over time, costs always compound against the investor.

Despite increased transparency and regulatory efforts, regular plans continue to command a large share of assets. Legacy distribution systems, investor inertia, and limited understanding of long-term cost implications have kept many investors locked into higher-cost options. While investors frequently track returns, few translate expense ratios into absolute rupee losses over extended periods.

The findings underline a critical lesson: selecting the right plan is as important as selecting the right fund. Market cycles, fund manager performance, and asset allocation all matter, but costs quietly determine how much of the upside investors ultimately retain.

As the study suggests, ignoring expenses can turn compounding — often celebrated as an investor’s greatest ally — into a persistent drag on long-term wealth creation.