What’s better – Investing in equity mutual funds or investing directly in stocks?

Amit has been investing in mutual funds for the last seven years. He is not happy with the returns, as they have been much below his expectations. He invested in a few small-cap stocks in March 2020. Some of those stocks have given more than 100 per cent returns in the last three-four months.

However, Amit did not really invest big amounts in those stocks. Hence, those investments have not made a meaningful difference to his portfolio.

Now, he wants to revisit his entire equity strategy. There is a sense of disillusionment with mutual funds and he is unsure if the mutual funds are worth investing in.

He wonders whether investing directly in stocks is a better approach than investing in mutual funds.

Flavour of the season approach

Amit has not focussed on allocation within various equity categories and has gone with the flavour of the season approach. He invested a lot of money in small-cap funds in 2017 when small-cap stocks were doing well. But the small-cap stocks have been under pressure since the beginning of 2018. While the broader equity markets have done not too well over the last couple of years, Amit’s portfolio has struggled even more due to higher allocation to small-cap funds.

Whether he invests directly in stocks or through mutual funds, the underlying exposure is to a volatile asset. Both the approaches have merits and demerits. If he gets his direct equity picks right, he can earn above-normal returns. However, if his bets go wrong, there can be serious wealth destruction. Mutual fund schemes have diversified equity portfolios and help hedge bets. While this reduces return potential, this also reduces risk.

Amit’s stock picks did very well over the past few months, and he deserves credit for his choices. However, he must not mistake luck for skill. Stock research requires time and skill. Four or five months of investing or getting two or three stock calls right does not establish skill. If he is very keen on investing a significant portion of equity portfolio in direct stocks, he must test his stock-picking skill and market judgement for a few years. Only then, should he allocate greater capital to direct stocks.

By the way, over the past four-five months, even some small-cap funds have returned more than 50 per cent. A rising tide lifts all the boats. Amit must remember that something similar happened in 2017 and he has experienced the subsequent pain. While no one can say with certainty whether the performance of the past few months will sustain or there will be a reversal, he must remain cautious.

At the same time, this does not imply that direct equity investing must be shunned completely. There is a middle ground. If Amit wants to take exposure to direct stocks, he must first set up a threshold for the direct equity exposure. For instance, he can limit direct equity exposure to say 20 per cent of the equity portfolio. Therefore, if his equity portfolio is ₹10 lakh, not more than ₹2 lakh should be in direct equity. This way, he can strike a balance between the two modes of equity investments.

Amit can set aside money for stocks that he has researched well and thinks offer potential for good returns. Mutual fund investments, if selected well, will diversify equity exposure. Therefore, this internal limit helps him retain upside potential of his stock picks. In addition, this helps him maintain discipline and not get carried away and take unnecessary risks.

If he is satisfied with the results of direct equity investments, he can increase the threshold after a few years.

Within the mutual fund portfolio, Amit can split investments across two-three funds. He can invest in a large-cap and a mid-cap fund. Or he can pick up a multi-cap fund. Remember four small-cap funds do not build a diversified equity portfolio. If he does not trust active fund management, he can simply invest in index funds or exchange-traded funds (ETFs). There are now passive options across the market spectrum.

The word “diversify” has been used loosely when referring to equity mutual funds. Note that true diversification does not happen when you add different types of equity products to the portfolio. You diversify the portfolio by adding assets with low correlation. For instance, adding a fixed income product to an equity portfolio diversifies the portfolio.

Asset allocation is of vital importance. Sub-allocation within the equity portfolio is secondary.

(The writer is a SEBI-registered investment advisor at personalfinanceplan.in)

True diversification

Having assets with low correlation helps in true portfolio diversification