How a MF (Mutual Fund) operates: Direct Equity vs MF which is better?

MF vs DE

Today, we have an interesting article which explains the working of a mutual fund and how it is better or worse than direct equity investment. Since most of the publications rally behind mutual funds and there is susbtanial money spent by funds on marketing, it is hard to find an article on the actual functioning of mutual fund & comparison of it with direct equity investment. We will present both the pros & cons and then it is up to you to pick one or blend both in your portfolio.

Basics

  1. Mutual Funds are pooled investment vehicles where a designated fund manager manages your money on behalf of you. He or she takes decisions keeping best interest of all investors in mind. Fund Manager is bound to follow strict SEBI regulations and fund house policies.
  2. Direct Equities are investments where an investor buys stocks directly and manages them as per his own thought process. He is not bound to SEBI guidelines on portfolio management. It is his own decision and is fully responsible for the gain or loss.

How Mutual Fund works

Mutual funds have possibly among best paid research teams & best available analytics tools to examine various investment opportunities and keep a track of them. Depending on fund’s investment objective, research team keeps on looking for investment options. A large cap fund will only look for big companies, similarly a small cap fund will look for small-sized companies. Apart from that, they have to maintain a diversified portfolio where any particular sector can not go beyond 20-30% (depending on fund house policy). It has a maximum of 10% exposure cap for a single stock (this is SEBI rule). Apart from this, a mutual fund has to honor payment to a redemption request within three working days irrespective of market conditions.

Pros of Mutual Funds

I assume most of our readers already know about this, so I will keep it short. In summary, mutual fund offers you a professional money manager and best research capabilities. It will also ensure enough liquidity, so you can buy and sell units anytime you want. It is bound by regulations & policies. The best part is that it off-loads investment decisions from you to experts, so you can be stress free and focus on other things in life.

Cons of Mutual Funds

Being a pooled investment and bound by fixed regulations & policies brings various handicaps as well. These cons are not actively highlighted in media campaigns for obvious reasons but as investor, you must know about them as well.

  1. Pooled Money: Mutual funds are not personalized investment portfolio, they work in benefit of all investors which at many times will not work in your interest. For example, considering a scenario of a bull market – Let’s assume a fund purchased a good stock at a reasonable price after which being a good stock, its stock price went up (thanks to good research capabilities). Due to good performance, new investors beeline to get into this fund. Fund manager can’t say no and has to buy new shares at quite higher price for the same stock. This will impact potential future returns since stock is averaged at much higher price with each new shares being bought. Another option is that fund manager will hold fresh money as temporary measure but he can’t do that for a longer period. So another options is that he will enter into a new stock to park fresh money. This is also bad since his portfolio bucket will swell with 100s of stocks which will again impact returns as not every stock is going to perform even with best research. Similarly in a bear market – Investors will want to sell their holding asap which will mean fund manager will liquidate his stock positions at much lower levels, where as ideally one must add more money or at least hold in bear phase. So in both scenarios, you see that mutual funds are forced to follow herd mentality (buy at higher price, sell at lower price) while it should be exactly opposite.
  2. Regulation & Policies: Funds have a strict mandate from SEBI to limit maximum exposure in a single stock to less than 10% of the portfolio. Clearly mutual funds are not going to have multibaggers in their portfolio. They may choose to enter & exit same stock or keep on pruning their money to keep exposure below 10%. These regulations are static and were formulated in 90s, they handicap a mutual fund to have good exposure in a promising stock. Apart from this, fund house policy to cap sector exposure will also restrict a mutual fund to hold multibaggers in their portfolio.
  3. Performance Pressure: Internally, Fund managers have to justify salary to their management and have to generate constant returns so that fund house can keep on getting more inflow of money year on year, quarter on quarter. They can’t sit on a stock which is not moving at all since it will hamper portfolio performance of the year and they will face heat from management. We all know that stocks need time to become a multibagger. There will be periods of silence followed by periods of burst (Click here to read our earlier article to understand the behavior of multibaggers). So in the end, this is also counter productive to individual investor’s interest.
  4. Management Fee: Most mutual funds charge you somewhere between 1.5% to 3% as management fee. The argument is that since you get best money managers & best research, this is our expense to maintain it. It is true from a business point of view but not from an investor’s point of view since we can see the advantage of their research capabilities or manager expertise is nullified because of being a pooled investment vehicle which follows herd mentality. At single glance, 2-3% expense ratio may not seem harmful but over a period of time, it is significant since it is compounding every year.
  5. Liquity Concerns: This is true especially for small cap funds since they can’t invest in smaller companies at all and even if they invest, they can’t do it without disturbing stock’s market price. This limits their ability to invest in a stocks during early phases of growth. You might be wondering why a number of high performing small cap stocks feature quite late into a mutual fund portfolio. It is not because their research house was unable to spot them but it is because of liquidity concerns. For example, let’s assume a mutual fund having assets of ₹ 2000 crores. If this fund plans to invest only 2% in a stock, it will be around ₹ 40 Crores. Let’s take the case of a small cap stock with a market capital of ₹ 500 Crores out of which 60% is held by promoter, another 10% held by small institutional investors, leaving around 30% for public. It translates into ₹ 150 crores worth of shares with public and on any given day, only ₹ 15 crores of stocks are being traded (assuming 10% float). Clearly mutual fund can’t enter or exit such stocks without testing upper or lower circuits. No fund manager wants to be in such a situation where it does not find buyers or seller, so he will possibly wait for this comapny to grow from ₹ 500 crores to ₹ 1500 crores or so. This will enable him with easy entry & exit options. This is even more difficult in case of good small cap stocks like Sandesh Limited, where promoters hold 75% of shares & further 10% is held by local investment firms, leaving only 15% of shares floating around. This is where you as individual investor have an edge over mutual funds unless you are going to invest in crores in a single stock.

What is the best Approach?

To draw a parallel for easy understanding, mutual funds are similar to a well regulated public bus which carries a lot of passengers to serve their interest, follows all rules and takes a lot of stops. Direct equity investment is like your own private car which is driven by you, runs faster (high return) than public bus and stops only at your destination.

If you are a beginner in equities, go for mutual funds, very simple! But if you are someone who has spent considerable time in the market & has a good investment process, then mutual funds are not the best solution for you. Mostly, a well-managed individual portfolio will surely give you higher returns than mutual fund over a period of time. The caveats are investment discipline & good investment process. Personally, I have my money divided into 40% mutual funds & 60% direct equities. So, you can choose to adopt a mix of both worlds to get better results. You can look for some professional advisory service provider like us to stay on right path and generate multibagger returns (Click for 16x in 10 years). Since they will not have the cons of a mutual fund but surely some pros of a mutual fund with a fixed fee (not a percentage), your money will get better returns in a blended approach.

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