BackDYK: Why equity mutual funds are a better choice for retail investors
Equity MFs are regulated to ensure that fund managers don't overload stocks from one sector
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Buying direct stocks and investing in equity mutual funds (MFs), each have merits, but before deciding which way to go you must understand the nuances. Also, direct investing can be riskier. An equity MF is a basket of equity shares which is managed professionally. MF investors receive units proportional to the amount invested. The professional management of funds comes at an annual cost, which is deducted directly from the value of the MF unit. Here are two reasons why equity MFs work better for retail investors.
IDENTIFYING GOOD QUALITY COMPANIES AT THE RIGHT PRICE
If you are buying stocks directly, identifying good quality stocks which make the cut as long-term investments, may not be difficult. For example, ABC Ltd, a listed company, is the leader in the domestic small car market and it’s backed with good quality management; you may conclude this makes for a good investment. But is any price good to buy the stock?
Buying equity shares is also about identifying the right price. This is easier said than done. Data shows that returns from some of the highest market capitalization stocks in the domestic market have trailed benchmark returns for longer periods than expected. The stock of Tata Steel Ltd, for example, fell 27% since January 2014 and Reliance Industries Ltd’s stock gained only 11.2% compared with a 33% gain in the benchmark CNX Nifty in the same period.
This happens because stock markets are imperfect and often the price at which a stock is available either overstates its future growth or understates it. So, it is important to ascertain that the stock of a good quality company is either under-priced or at fair value. Probability of matching your expected return is high if the above is true. This requires in-depth research and analysis.
MFs are managed by professionals well versed with stock pricing and valuation methodologies. They are better placed to identify which stocks warrant buying despite stretched valuations and undervalued stocks. Picking the top 3-4 fund managers who consistently beat the benchmark might be easier than picking the same number of stocks.
DIVERSIFICATION
You have to consider portfolio diversification. Buying direct shares has the potential to overlook appropriate diversification across sectors and themes. Having a concentrated portfolio means that you will feel the impact of specific corporate actions and events related to your stock much more. Say, you have four stocks in your portfolio—two banks, one automobile and one real estate. While these companies may be good, what’s overlooked is that they are all sensitive to interest rate cycles and this can affect prices in the short term. Negative news on interest rates could mean correction for the entire portfolio.
Equity MFs are regulated to ensure that fund managers don’t overload stocks from one sector (except if it’s a sectoral fund). Most fund managers have diversified portfolios with anywhere between 30 and 60 stocks on average. This allows them to de-risk the portfolio from over dependence on a particular company, sector or event.
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