Can individuals expect to beat mutual funds?

Individuals have a choice of taking direct equity exposure or buying equity mutual funds. The decision to choose one over another is crucial to the portfolio management process; for a wrong choice could reduce the likelihood of meeting the desired investment goals. We had discussed the choice between mutual funds and wealth managers in this column earlier. We are prompted to revisit this discussion because of the continued belief among investors that direct equity exposure can outperform mutual funds. The question is: Can individuals consistently outperform mutual funds?

This article explains the process required to take direct equity exposure. It then discusses the benefits of investing in mutual funds and shows how investors can optimally combine both to create niche portfolios.

DIRECT EXPOSURE

Investors should possess security selection skills to engage in direct investment — this is the skill required to consistently pick stocks that outperform the appropriate benchmark index. Now, selecting securities isn't without risk.

For one, portfolio theory strongly argues that investors will not be necessarily rewarded for taking security-specific risk; for such risk can be diversified away. That is, investors can expect a reward for taking market-specific risk, but not for taking security-specific risk. This means that consistently earning excess returns above the benchmark index (called alpha) will be more difficult than earning the benchmark return (or beta).

For another, selecting securities requires an alpha strategy. But a strategy will generate alpha only if it is unique. If many investors follow the same strategy, the demand for the same universe of stocks will hike their prices. And that, in turn, would arbitrage away the excess returns or the alpha. An individual should, hence, continually develop newer alpha strategies. Otherwise, alpha is likely to fade and the portfolio will primarily generate the market returns or the beta.

It is moot whether individual investors can actively engage in this process. For one, individuals have to invest time and effort to formulate an alpha strategy. For another, they need to continually review alpha for its fade rate. Given these requirements, it would be difficult for individuals to consistently outperform mutual funds.

FUND EXPOSURE

We list below some reasons why individuals should consider mutual funds. One, in the core-satellite portfolio approach, the core portfolio has passive equity exposure. It is easier and cheaper to use mutual funds and exchange-traded funds for the core portfolio, compared to direct investments in stocks that constitute the benchmark index.

Two, investors are typically concerned regarding their unrealised losses when asset prices decline. Maintaining direct exposure will lead to tension, as individuals will be mindful of individual stock losses. Investing in mutual funds moderates the tension because individuals are not provided the portfolio composition; their only notable price is the net asset value. Since stocks within a portfolio can offset gains and losses, a sharp decline in the market need not automatically lead to a sharp decline in the net asset value.

Three, investing through mutual funds provides individuals access to a large universe of stocks and investment strategies. Consider an investor who has Rs 10 lakh to invest. She can buy several funds, ranging from large-cap funds to sector and thematic funds. Investing directly in stocks can restrict such exposure, for the investment capital required to set-up such a strategy is higher than that required to buy funds.

That said, mutual funds are standardised products while direct investing enables individuals to custom-tailor their portfolios. Direct exposure is, hence, optimal for the satellite portfolio.

CONCLUSION

Individuals should consider creating low-cost passive exposure to mutual funds for their core portfolio. Direct exposure to equity can be considered for the satellite portfolio for two reasons. One, such exposure offers individuals a better opportunity to exploit short-term market movements, as mutual funds are typically not market timers. And two, High-Net-Worth Individuals can hire investment advisors to create near-pure alpha strategies to suit their requirement.

The choice to invest directly in equity should be primarily driven by the need to custom-tailor exposure, not with the expectation to consistently outperform mutual funds.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com)