Mutual Funds or Direct Equity?

Introduction

If and when you decide to invest whatever percentage of your capital in equities (shares or stocks), you have a fairly wide variety of options to choose from. However, in this blog post, I will focus on public equities and will compare the two possible approaches i.e. direct investment in equities or through mutual funds. Both are viable options with their advantages and limitations. The purpose of this discussion is to see what suits whom.

Mutual Funds

Mutual funds are firms or institutions that manage other people’s money in return for a management fee. This is their business model. They hire financial experts and analysts for this purpose. Mutual funds may invest in a variety of products like debt and equities or a combination of the two.

There are two types of mutual funds i.e. closed-end and open-end mutual funds. The basic character of both funds is the same. They invest a large pool of money on behalf of the investors, however, they differ significantly in the way they operate.

Closed-end funds (CEFs) raise investment capital through IPOs in the secondary market (stock market) and thereafter the shares of funds are traded in the stock market just like any share or stock. The supply and demand dynamic plays its role and the shares are available either on premium or discount, relative to the NAV (net asset value). These funds are comparatively uncommon.

Another variant is the exchange-traded funds (ETFs). ETFs and CEFs are similar in their operation but differ in terms of fees, transparency, and pricing.

Open-end mutual funds are more common than CEFs. In fact, when we refer to mutual funds, we imply open-end mutual funds. Unlike CEFs and ETFs, these are not traded in the secondary market. You can buy them from the primary market only i.e. the fund managers. Their unit price is updated once every day, after the trading hours in the stock market, and it is called NAV (net asset value).

Investing in Mutual Funds

Henceforth, when I refer to mutual funds or just funds, I will mean open-end mutual funds: the most common version. The characteristics of the mutual funds are being discussed in the form of pros and cons:

Pros

Mutual funds are most suitable for beginners or novices.
Those individuals can also invest in mutual funds who have either no liking or aptitude for finance and accounting or they can’t allocate any time to investing due to other commitments.
While investing in mutual funds, you have a satisfaction that your funds are being managed professionally.
Since you have no control over your investments after you get into the fund till you get out, you don’t feel the emotional pressure to act in extreme market situations.

Cons

You have to pay the managment fee (aka expense ratio) which can be as hight as 2% per annum. In the long-term, this means a substantial amount. According to the regulations, charging managment fee has nothing to do with the performance of the fund.
Like stocks, there is a wide variety of mutual funds in the market to choose from. For a novice, it is very difficult to know which fund will perform well. If selecting a fund is that hard, why not to select shares directly.
Barring few exceptions, the fund mangers tend to play safe and avoid radical stock selection as they can’t afford to be wrong due to fierce competition. Therefore, their purpose in investing is to remain close to or slightly better than the market average. You can do it yourself without the help of mutual funds and save the management fee also.
One of the most glaring limitations of mutual funds is that the fund managers don’t have any control over the availability of cash. Inflow and outflow of the cash is being decided by the individual investors. When the market goes down drastically, the valuations are cheap but the fund managers can’t buy more shares, despite wanting to, becasue the investors are panicking and they want their money back and no fresh money comes in. The opposite of this happens when the markets go up significantly. This reflects in the fund’s NAV/ performance.
Historical data shows that a vast majortiy of funds perform worse than the market during any 5-7 years or longer period.

Buying Equities Directly

Like going through the mutual fund’s route, buying shares directly from the stock market has its merits and demerits too. The investors must weigh their options and decide accordingly.

Pros

While investing directly in the market, you can save the management fee that you have to pay to the mutual funds. This can be a significant sum in the long-term.
You have full control over the stock selection and your buying/ selling decisions.
You have full liberty to design your portfolio according to your termperament and perculiar needs.
If you have a flair for investing and you can spare some time, direct equity is better than mutual funds.

Cons

You will have to carry out necessary research for stock selection yourself which needs time and effort.
Every extreme situation in the market will pose an emotional challenge demanding a decision to buy or sell. This may not be good for the overall performance of your portfolio.
Making your direct equity portfolio a success in the long-term is a challenge and the entire responsibility lies on your shoulders. Especially in a bear market, your patience is really tested.

Summing up and Adding Some DOs and DON’Ts

After giving a detailed comparison of both the options, I will sum up the discussion and will also include some guidelines here for optimum results:

In the light of above discussion, first, look inwards to find out what suits your financial needs and what you prefer.
If you are interested in finance, basic accounting and business analysis etc and can spare 3-4 hours every week, you should buy equities directly.
For this purpose, read some authentic books of well known authors, listen to some podcasts or watch relevant and good quality Youtube videos to hone your stock picking and portfolio management skills and you are good to go.
This way you will have full freedom and flexibility to pick stocks and design your portfolio according to your needs and expectations. You will also be able to save the fee you have to pay to the fund manager.
If you decide to buy equities directly, my recommedation is to buy good quality businesses at reasonable prices, while ensuring sufficient diversification, and then hold them for a long period. By a long period, I mean 5 years, 10 years, 20 years or a life time!
Even while investing directly in the stock market, you can get help from mutual funds. Shortlist some 4-5 top quality funds and see their shareholding pattern. They are obliged by the regualtor to declare it and you should be able to find it on their website. Taking a lead from this, you can plan your own investments.
If you are not willing to or cannot do the required homework and still want to invest in stocks, the mutual funds route is perfectly suitable for you.
Choose your fund or funds carefully. Avoid new funds as they don’t have any track record.
Also avoid sector funds or the funds that are following a particular investment theme because their investments are highly concentrated in a particular sector and defy the fundamental rule of diversification.
The best thing to do is to select 3-5 well established broad-based funds, having good performance record of at least 10 years, and start an SIP (systematic investment plan) into these funds.
You may also like to invest in an index fund. Yet another option is to mimic any stock market index in your direct equity portfolio. This will free you from the hassle of picking stocks yourself but this also means that your portfolio will perform, more or less, in line with the index.

Conclusion

It is evident from the above discussion that both direct equity as well as mutual funds are feasible and valid solutions. You have to see for yourself what is suitable for you and then decide accordingly. If you are willing to spend some time developing a process of your own, go through the relevant content, and then take a plunge, direct equity can reward you richly. Otherwise, you will have to trust some funds and if your selection is right, you can expect good returns in the medium to long term.

How did you find this content? Please comment and give suggestions, if you have any.

My other articles you may find useful are:

How to Make a Personal Financial Plan – Basic Considerations

Personal Finance – A Suggested Checklist

Investment vs Speculation

A Brief History of Money

Why I Started a Blog on Personal Finance

Anatomy of Financial Risk

Debt, Equity, and Real Estate: An Overview

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

How Stock Market Works and How to Work in Stock Market?