For a common retail investor, there are two ways to invest in equities - either directly purchase stocks of listed companies through a demat account, or indirectly hold equities by investing in an equity mutual fund. Both of these options have their relative benefits and associated costs, and what is the right choice for an individual really depends on their specific needs and sophistication.
Equity mutual funds are a basket of equities managed by professional fund managers, investing in a large and diversified pool of equity stocks. As an investor, one only needs to invest the desired amount and become a part of the fund holdings, and let the professional managers do the job. This however comes at a small cost, and one needs to evaluate the following advantages of Equity Mutual Funds over Direct Equity investments before deciding what is right for them.
Instant and affordable diversification
Equities are inherently risky and hence it is prudent to diversify to better manage the risks. Mutual funds are well diversified as they hold a large number of equities (e.g. 30-50). This enables mutual funds to survive even if few of the equities they hold do not do well. When you invest in a mutual fund even a small amount (e.g. Rs 1000) it becomes a part of a diversified portfolio and you achieve instant diversification. Compared to this building a diversified portfolio as a direct equity investor takes significant more work (identify multiple equities which will help diversify, buy equities of each company) and money (to buy the minimum number of equities of each company).
Active portfolio management
Active portfolio management is the cornerstone of successful equity investment. Equity mutual funds employ skilled investment professionals who take up the responsibilities of full time fund management. This team has the expertise to continuously monitor the Indian and global markets, performance of portfolio companies’ etc. to take informed decision related to identifying, buying, holding and selling equities. Direct equity investors will need to spend significant amount of time and be highly disciplined about investing to provide comparable level of management.
Robust risk management
Often an individual lets sentiments sway her/his investment decision making them overinvest in a particular stock (e.g. believing on a tip, getting investment advice from others) leading to bitter experiences when things don’t pan out as expected. Equity funds however cannot do so due to multiple risk management guidelines (e.g. investment limit per stock) and tools to filter out sentiments from portfolio decisions. Investments decisions are based on strong research conducted and vetted by investment teams.
Low transaction costs with economies of scale
Active portfolio management often requires buy/sell transactions. As a direct equity investor with a small portfolio value, the average transaction cost will be much higher compared to equity mutual funds that can negotiate substantially lower transaction costs due to economies of scale thus enjoying a large pooled portfolio. Over time, such transaction costs eat into the returns of direct equity investors compared to equity funds. The equity mutual funds also charge an expense ratio, typically 2-2.5% annually, as their fees for managing the fund. However, the benefits to a retail investor far outweigh this cost and the net returns are still likely to be higher.
Innovative investment/withdrawal options
The scale of mutual funds allows them to innovate and come up with features like Systematic Investment Plan (SIPs) that increase over time, systematic withdrawal plans (SWPs) etc. Such innovation help investors be more disciplined about investments and also offer them seamless experience of entering, managing and exiting from funds.
The choice between the two models of investing in equities depends on individual’s risk tolerance, market expertise and time for research. Direct equity is recommended for those investors who can select great stocks and know the equities markets deeply. Young investors getting started in equities and common investors with limited time to monitor investments should invest through equity mutual funds as they provide multiple advantages summarized below:
- Instant and affordable diversification
- Active portfolio management
- Robust risk management
- Lower transaction costs
- Innovative investment/withdrawal models
The author, Manish Hermajani is CEO & Co-Founder, FinAskus.