In my last article on What is Equity? and Why stock prices move up and down? I had discussed in detail about Why equity is an important asset class? and why share prices move up and down over long term and short term? Now the other question that investors have about equity is whether they should invest in equity through Mutual Fund route or directly in shares. So, in this article I have tried to analyze the difference between the two.
Apparently it seems that investing in direct equity shares and making money is easy and simple but let me tell you it is difficult. I have observed that most of the times layman investors either lose in direct equity share portfolio or make very less returns. If they have invested in 10 stocks, they make very good returns in 2 or 3 stocks, but normally in most of the cases I have seen that they lose heavily in few stocks. So overall gain in the portfolio is not very attractive . When I go into detail and analyze why this happens I find that clients are not able to understand risk properly and they are very poor at risk management.
In Equity as an asset class, investors face mainly two types of risk. One is Systematic risk and another is unsystematic risk. Let us understand both the type of risk and their implications in direct investment in equity shares and investment in equity mutual fund.
Systematic Risk:
Systematic risk is the risk that is caused by the factors affecting entire market or a particular segment of the market. Systematic risk actually refers to the common factors affecting economy or a segment of economy like inflation, recession, interest rates. All these factors will affect the entire stock market or major part of it. Systematic risk cannot be completely avoided. It can be managed to a certain extent by using strategic asset allocation.
Now whether you invest in equity shares directly or through Mutual funds you cannot avoid systematic risk. It can only be avoided by strategic asset allocation.
Unsystematic Risk:
Unsystematic risk is the type of risk which is specific to that particular company or industry. For example, if entire economy and markets are doing well but one particular company has some internal problems and due to that its share price is falling then it is unsystematic or specific risk. Now it is very difficult to manage this type of risk by investors in direct shares but it is properly managed by mutual funds due to following reasons.
- Diversification: For a layman investor, it is very difficult to understand business models of different companies and their industry. It is also difficult for a layman investor to keep close watch and understand relationship between events happening in the company and economy and its impact on the share price of the company in which they have invested. So they cannot diversify beyond few companies but Mutual funds have team of research analyst and fund managers who can keep close watch on more number of companies. So when you invest in a mutual fund, you invest in a portfolio of around 30 to 40 stocks. Normally a mutual fund company has its investment world of stocks in which they continuously research through their team of research analyst. As against this, for a layman investor it is difficult to understand fundamentals of this many companies and to track the events of so many companies. Suppose an individual investor is investing his entire corpus in 5 companies then the risk is high as against investing in a mutual fund where the investment goes into a portfolio of 40 stocks. So when you are investing in mutual fund, you are creating a well diversified portfolio where company specific risk is low due to large diversification.
- Professional Management : Mutual fund portfolio is professionally managed portfolio. The fund manager and his team is technically qualified and experienced for equity research. They can afford the use of latest technology and have availability of detailed data related to companies and economy. Whereas for individual investors it is difficult to technically understand companies fundamentals and keep continues track of its working. An individual investor also has a limitation to availability of data or sometimes he receives data very late. So it is better to invest through experts.
Additional Management Expenses by Mutual Funds:
As we saw in our discussion that investing through mutual fund is much better than investing in direct shares,but it also has a cost. Mutual funds charges around 2% to 2.75% on the funds value on annual basis. But can an individual investor hire such experts for his fund management? Can he use such an efficient technology to analyze markets and companies? The answer is NO. So here mutual fund actually acts as a pooling vehicle. Say if you are travelling from Baroda to Mumbai and you choose to travel by your own car, you may have to spend a few thousand rupees on fuel and you also have to drive on your own or you can hire a driver. Whereas when you travel by a train, you have to pay only a few hundred rupees and you will reach Mumbai without any hassle of driving or anything. Similarly, here mutual fund acts like a train. Here in below table I have highlighted long term returns of a few mutual fund along with returns of their Benchmark indices. We can clearly see that all these funds have beaten their benchmark indices with good margin and these returns are post expenses. So it is worth to pay such management expenses.
Conclusion:
My experience says that effective risk management is the key to become a successful equity investor and mutual funds help investors to manage their unsystematic risk effectively. So investors should adopt mutual fund route to invest in equity. This will help them to generate long term wealth.