Investing in Mutual Funds v/s Direct Equities

The new-age millennial investor today has a plethora of options when it comes to financial investment. However, one thing that hinders their decision is choosing between mutual funds or investing directly through equities. Vardan Pandhare lays bare the nitty-gritty of this investment process to resolve your issue

It is a known fact that many investors decided to park their funds directly in equity as a result of the upward movement of benchmark indices witnessed till the latter part of 2021. The equity market as an investment avenue is straightforward but challenging as well. With the level of volatility it experiences, patience is essential. Today, most of the market players are wondering whether this situation is sustainable given that the returns generated over the past year have been on the lower side. And this has raised another crucial query: is exposure through mutual funds preferable over direct equity exposure and what is a better investment option: mutual funds or direct equity investing?

Since the emergence of the pandemic, the world has undoubtedly undergone a significant transformation. The situation is completely changed from what it was a year ago. Not just in India, but throughout the world, the dynamics have altered. Although everyone believes that only their social lives have been impacted, the reality is that it has affected people on professional and corporate fronts as well. Likewise, the world of investing is not an exception. To be clear, we are not just discussing how the equity benchmark indices tested their annual lows during the pandemic before rising to new record highs. We are talking about how the penetration of the equity market has grown over time.

Historical Rise in Trading Accounts 

According to the information given by the two depository companies, the Central Depository Limited (CDL) and the National Security Depository Limited (NSDL), India’s total number of demat accounts surpassed 100 million in August 2022. This is the first time in India’s history that such a milestone has been reached. Before the first lockdown, which was in March 2020, India only had 40.9 million or roughly 4.1 crore demat accounts. However, reasons like a significant expansion in the market, work-from-home options, increasing internet service penetration and the need for a second source of income were responsible for the country’s sharp rise in the number of people with trading accounts.

Around 2.2 million new demat accounts were opened in the previous four months, according to NSDL and CDL data. Since there are more than 100 million demat accounts, CDL manages around 71.6 million accounts while NSDL manages approximately 28.9 million accounts. These two depository institutions have a combined amount of ₹38.5 trillion and ₹320 trillion in assets under custody (AUC). The expansion of the stock market’s investor base can largely be attributed to lower brokerage fees and optimistic market growth predictions for the near future. Even more encouraging is the fact that Tier II and Tier III cities have produced a majority of the new demat account holders over the previous two years.

Assess your Risk before Investing

Investors must overcome several biases because investing is primarily a psychological game. Recency bias is the biggest problem that new investors or retail investors encounter. This indicates that people base their choices on current historical events. This is similar to how equity benchmark indices have changed since April 2020, when new investors have had great success. No doubt, equity would always be preferred over mutual funds as most participants (especially new entrants) like to acquire exposure to the direct stock route given the recent performance of the equity market. Every asset class carries a variable level of risk, just as every person’s risk profile is unique.

Simply put, the risk in mutual funds and stocks is quite different. Direct equity exposure, in other words, is always a high-risk, high-reward proposition. While there is potential that the investor could end up with better returns, there is also a chance they could receive lower returns. Due to the asset class they invest in, equities mutual fund schemes have a higher risk, yet they nevertheless have a diverse portfolio. If the amount invested is lesser, this diversification is not possible in individual equities ownership. Any negative return on a single stock in a mutual fund can be offset by higher returns produced by other stocks thanks to diversification and the ability of fund managers to stabilise the equity mutual fund portfolios.

Who is Ahead in Terms of Diversification?

As previously said, diversification offers several advantages. A well-diversified portfolio should have at least 15 to 20 equities, but for an individual investor, that may be a sizable investment. Imagine the level of diversification a new investor can achieve with just ₹5,000–₹10,000. However, diversification is rarely feasible when investing directly in equities. But, in the case of mutual funds, even with a small investment of between ₹500 and ₹1,000, one can still have a diversified portfolio. An investor can invest in several stocks without having to make a sizable initial investment by purchasing units of a fund.

On top of that, your money is being looked after by the best fund managers and that too with little to no additional expense. The mutual fund indeed performs well here, but portfolios aren’t created overnight. You can start an equity SIP to build a well-diversified portfolio. Additionally, some stocks have a limited equity basis, making them inaccessible to institutional investors. In that area, numerous winners can become multibaggers with only a little exposure. Keep in mind that all it takes to succeed in the markets is one such move. 

Core Competencies Matter more than the Markets

Financial investment is a masterful field and therefore it also demands a lot of concentration, commitment and time. It might be simple, but it’s definitely not easy, as we said previously. One could be a specialist in a certain area. A person might be an excellent salesperson, technology coder or a specialist in a certain field. It is usually advisable to stay in the area in which one is an expert because doing so would likely result in the individual earning more money. It could not work out well if we try to earn from our primary occupations while also dabbling in investing. We suggest that the investor leave investing to the professionals. Investment in mutual funds specifically aids in this. Imagine how challenging it would be to work on equity investments and your primary profession simultaneously. Some people wouldn’t be able to multitask in this manner.

Who has the Upper Hand? 
 

One advantage of investing via mutual funds is that you don’t have to choose the stocks yourself. The process is carried out by an experienced fund manager who is a specialist in his field. In direct equity investment, choosing stocks, keeping track of them, deciding on sector and asset allocation, and buying and selling stocks as necessary take constant attention and time. However, in the case of mutual funds, it is the responsibility of fund managers to conduct research and allocation after choosing a mutual fund scheme that is in line with one’s financial goal. And in our opinion, a qualified fund manager usually does it best.

Investors have been known to begin stock investments with enthusiasm, but as the job becomes monotonous and rewards become scarce, they begin to lose interest. Portfolio stagnation is the eventual effect. After a few years, a few portfolios become so out of date that many of the stocks in such portfolios either go out of business entirely or, more often than not, rarely offer any exit strategy. An investor can totally avoid these circumstances by investing in a mutual fund. It is run by a qualified fund manager who will make sure the portfolio has high-quality equities with the potential for long-term gains. Additionally, ordinary investors would barely have access to the kind of network, research capacity, financial tools and connections with corporate management that mutual fund managers have. Last but not the least, performance bonuses are tied to portfolio performance; as a result, fund managers focus on generating returns and maximising profits.

According to Sudarshan Raut, a long-term investor, “I have been investing on my own using my demat account and I have been investing in equity MFs systematically. To adhere to your financial plan (goal-based investing), MF investing is easy and practical. However, when it comes to targeting aggressive returns for high-risk appetite, I prefer direct investing. I can invest in Penny Stocks and turnaround stories and aim for multi-bagger returns, which is not possible with MF investing. However, it is a high-risk business and one must be an informed investor to participate directly in the markets. Most of us are not informed investors and hence MF investing is a better investment vehicle. If you have the right temperament and can independently do equity research and build your own conviction, direct investing is for you.” 

Analysing Performance Parameters

To understand which is better – direct equity or mutual funds – we carried out an analysis wherein we compared the calendar year performance of various mutual funds categories with that of the S&P BSE Momentum Total Returns Index (TRI). The reason for comparing it with a momentum index is that most people invest in stocks based on their past performance. Momentum investing is based on the same premise or rather is its updated and subtle version.

As can be seen in the above table, neither mutual funds nor direct equity (S&P BSE Momentum TRI) consistently beats each other. It can also be observed that investing in direct equity works in your favour when the market booms. However, during big losses such as the one witnessed in the year 2022, it performs poorly. Having said that, investment in direct equity requires prerequisite knowledge and experience to succeed and those who do not possess it can take the mutual fund route and let the expert manage your money.

Conclusion

In the end, the decision between mutual funds and direct equity rests on the choices of the investors. The variety of mutual funds and their expert management can be helpful if you are new to investing. They are also a smart alternative even for investors with fewer funds because of the low entrance barrier. Direct equity, however, may be a choice if you are a seasoned investor who is familiar with the stock market’s operations. But whether you want to invest in stocks directly or through mutual funds, it’s important to create a well-rounded portfolio that is in keeping with your financial objectives and risk tolerance. A safer choice for new entrants, according to the fundamental competency characteristics, is mutual funds. And by no means are we advocating staying away from direct equity investments. 

If one is willing to put in the time, investing in equity can be more profitable and worthwhile. Spending time analysing, monitoring and researching businesses and industries if the investor has enough investable money to create a diversified portfolio can be a win-win situation. However, a mutual fund appears to be a decent solution for individuals seeking secure growth while also attempting to beat inflation and achieve higher risk-free returns. Never use both feet to gauge a river’s depth, just to be safe. Use equity mutual funds to get started in investing. Direct stock exposure is a strategy that can be used once a critical mass and knowledge are reached.