Should we invest in Equity Mutual Funds or directly in equity shares?

There are two common ways, If we want to invest in equities. First option is we can open demat and trading accounts with a stock-broker to buy or sell equity shares in the stock market. Secondly, we can invest in equity mutual fund schemes.

Mutual fund is the instrument through which Mutual Fund companies pools the money of different people and invests them in different securities like stocks, bonds etc. Many retail investors think that, whether we are investing in mutual funds or through stock brokers, at the end of the day, we are investing in stock markets and therefore both types of investments are the same; hence the dilemma, whether to invest in mutual funds or directly in equity shares?

Here, we will try to understand the key differences of investing in mutual funds and investing directly in stocks.

1.   What is the Risk and Return?

As we all understand that Risk and Returns are the two most important aspects of investing. We invest our money to get returns. In certain investment products we can earn returns without taking any risk, e.g. bank fixed deposits, traditional life insurance plans, government bonds, etc. However, risk free return is the lowest expected return. Historically, risk free returns, on a post tax basis, has not been able to keep pace with inflation over a long time horizon. Hence, If we wish to beat inflation and want to earn higher returns, then we have to take some risks. Generally Higher the risk, higher the potential return, but is not always true. Higher risk and higher returns are fundamental attributes of both stocks and mutual funds, but from an investor’s perspective the question is, how much risk is the investor willing to take relative to returns he or she expects from his or her investments? A deeper understanding of risk is required.

There are two kinds of risk in equity investments, Systematic Risk and Unsystematic Risk. Let us understand both types of risks, with the help of an example.

Systematic Risk or Market Risk is a general market risk, like due to macro-economic factors, geo political reasons etc the market moves ups or down. For example when a single pro reforms political party gets majority in elections market takes it positively where as a hung parliament is taken as negative.

Unsystematic Risk is company or sector specific like Rupee exchange rate and US & European Country’s import policy could have direct impact on IT companies in India.

We don’t have any control over systematic risk and hence they are called uncontrollable risks. But we can reduce unsystematic risks to certain extent; It can be managed by understanding the characteristics of different companies, sectors and their business. how? This needs a detailed understanding and analysis of various sectors and companies. For an individual it may not be that easy however through mutual funds.

2.   Concentrated Portfolio or Diversification?

To reduce Unsystematic Risk, we should have a diversified portfolio, you need to invest in a sufficiently large number of stocks say 40 to 50 stocks to create to an adequately diversified portfolio. The share prices of the 50 stocks may range from Rs 50 to even Rs 25000 per share. As we know that we have to buy minimum one share and cannot buy fractional shares. Even if you buy just 1 share each of the 50 companies, assuming the share prices of the 50 stocks are uniformly distributed in the Rs 50 to Rs 25000 per share range, your minimum capital outlay can be more than Rs 100,000. And If we wish to buy more shares, our capital outlay will be higher. To achieve adequate diversification through direct equity shares, we will need a large capital investment.

Mutual funds, pool the money of different people and invest them in different stocks, in the right proportion, to create a diversified portfolio. The Assets under Management (AUM) of a mutual fund scheme is much larger ( few schemes have more than Rs. 10,000 crores in a single scheme) than the investible capital of an individual retail investor. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund. Therefore, by owning mutual fund units, the investors have the beneficial ownership of a diversified investment portfolio even investing, just Rs 5,000 in a diversified equity mutual fund. Hence we can get diversification benefits that would have required a few lakhs, if we had invested directly in equity shares.

Risk diversification should be an important consideration because it reduces the probability of losses. In terms of risk profile, for the same amount of investment, diversified equity mutual funds are less risky compared to investing directly in equity shares.

3.   Guesswork or Market expertise?

Generally the small and individual investors do not have the experience or expertise in understanding business of various sectors and companies which is required for right stock selections. Most of the retail investors in direct equity shares are speculative or based on guesswork or tips from friends, relatives or their brokers. If someone is investing in a stock, just because, the price has been rising for the last 3 weeks or a month or even a few months, it is still purely guesswork; just because a stock has been rising for the last few weeks or months does not mean it will continue to rise.

Mutual Fund managers have a team of analysts and fund managers who do fundamental analysis where they look at a variety of macro and micro economic factors, analysis of the companies balance sheets, income statements, cash-flow statements, management commentaries etc. Based on the forecast of these factors, employing a variety of methodologies, the fund managers and analysts forecast the future price of the asset. It needs certain set of skills and capabilities (which often includes speaking with the managements of the companies), which retail investors do not have.

A Mutual fund manager’s mandate is to outperform the relevant market benchmark returns. A good manager creates value for the investors through, what is known as, “Alpha”. Alpha is the excess return that the fund manager generates, over and above, the returns expected by the investor for taking a certain amount of risk.

4.   Trading or Systematic Investing?

Equity Share prices are very volatile it also affects the emotions of investors and thus can induce them to buy when market is going up and sell when it is falling sharply. This practise, normally, leads to losses for the investor. Historical data analysis suggests that, the effect of volatility reduces considerably, with increase in the investment horizon. Mutual funds, encourage investors to invest over a long time horizon to meet a variety of long term investment objectives like retirement planning, children’s education, wealth creation etc.

Systematic Investment Plans or SIP is a smart way to invest regularly. It helps investors to take advantage of short term volatility and invest in a disciplined manner by taking emotions out of the investment process which helps to meet their long term financial objectives. SIP also provides the advantage of Rupee Cost Averaging by investing regularly irrespective of ups and downs in the markets. This method helps us to buy units of a mutual fund scheme, both in rising and falling markets, which enables to average out the purchase price of units, resulting higher returns on the investments.

Historical data shows that, long term buy and hold is the best strategy to create wealth in the long term. Equity mutual funds provide solutions to investors to meet their long term financial goals through capital appreciation.

For someone who have lump sum funds to invest but is not sure about the market timing due to volatile conditions, he can invest in a low risk fund, such as liquid fund, and then purchase units of equity fund through a systematic transfer plan (STP). This help to average out the cost of purchase like in SIPs, along with that we also earn higher return on investment (liquid fund returns are usually much higher than savings bank interest). Such a facility is not available in direct equity investing.

Similarly, if we need regular Cashflow for regular expenses it can be done through mutual fund portfolio. Through systematic withdrawal plans (SWPs) an investor can draw a fixed or variable amount of funds from his portfolio. This way he can meet your regular income needs while, the balance invested will continue to earn returns. An investor can also opt for dividend options of mutual fund schemes to get tax free dividends.

And Finally

For small and normal investors who do not have expertise in equity markets, mutual funds are much better than direct equity investments. However If some one have the necessary stock selection and portfolio management skills, he can invest directly in shares through a stock broker. Investing in shares gives the freedom of selecting the shares and to decide when to buy or sell, while in mutual funds, investor will have to depend on the judgement of the portfolio manager. However, the knowledge, experience and judgement of a mutual fund who have team of analysts and fund manager, is likely to be much better than that of a typical retail investor. Henceforth mutual funds are more beneficial for normal retail investors, for meeting their long term financial goals.