Equity Mutual Funds or Direct Equity, Wonder What to Choose?

The up-move of benchmark indices over the last 15 Months as resulted in many opting to invest directly in equity. We understand that the equity markets are simple but not easy. With the kind of volatility it faces lot of patience is required. With last one year returns generation happening without any major decline, there is question in minds of most of the market participants – Is it a sustainable scenario? This lead to another important question, Is having a direct exposure to the equity is a better way or new entrants can have exposure to the Mutual Funds initially. Let us discuss what is a good way to invest, equity mutual funds or direct equity?

It is a known fact that, the world has changed a lot and since the outbreak of the Covid-19 pandemic. Things are not same they were a year ago. Not only India but the dynamics have changed all over the globe. While everyone feels it is just the social life that has got affected, the scenario has changed on the professional and business front as well. And the world of investment is also not an exception. Let me be clear, we are not speaking only about the equity benchmark Indices testing yearly lows and then achieving new historical highs during the Covid-19 pandemic. We are speaking about the way equity market penetration has increased during this period.

Just put the numbers in perspective, from 40.10 million trading accounts in India in February 2020, the number has gone up to 47.6 million trading accounts in October 2020. And the way benchmark indices have been moving northwards since April 2020, the number has crossed the 5.5 million mark as on March 31, 2021. This is a tremendous growth witnessed in terms of equity market penetration. For long it was considered an expert domain and hence the penetration was lower for long period. But the traction has increased over in the past two years.

Equity and Mutual Fund Investment Witness Traction

There have been many reasons that resulted in the rapid growth of new trading account openings in India. While many faced salary cuts, some lost jobs and opted for trading as an additional way to earn. Further, technological platforms like discount broking and online trading made things easier for them. Lastly, adding to that returns (consistent returns as markets made only upward move), the equity market generated in the last 15 months (starting April 2020) has attracted many new investors in a big way. Not only the average investment corpus size increased, but the duration of average closure time of demat Account has also increased. Earlier the average life span of a new De-mat account was six months. The scenario has changed and hence hardly any closures have been seen

While the direct equity participation has increased, the exposure to equity related mutual funds schemes has also increased. To put the numbers in perspective, Asset under Management for the equity-related schemes in March 2020 was to the tune of Rs. 7,73,427 crore. This has increased to Rs. 14,39,004 crore in March 2021, up by 86 per cent.

If we take a look at the data, it is visible that both the segments have witnessed a good traction, however, the returns generated through the direct exposure to equity would be higher than what the mutual fund investment has generated. There are many equity diversified schemes that underperformed the broader indices (especially in the small-cap and mid-cap scheme space). However the direct Equity route is also associated with the high risk and volatility. No wonder, there is a confusion in the minds of investors if one should go for direct equity exposure or should opt for equity mutual funds? Let us discuss the pros and cons of both investment options.

Risk Profile – An Important Factor

Investing is more of a psychological play and hence the investors have to overcome different biases. And the most important one retail investors or new entrants face is – recency bias. This means the decisions they take are based on the recent historical events. Similarly, the way equity benchmark indices have moved since April 2020 – giving a lot of success to the newly entered investors. Everyone would prefer equity over equity mutual funds. As the recent performance of the equity indices is very good, most of the participants (especially the new entrants) would prefer to take Exposure to the direct equity route.

However, one must understand that this is a unique scenario when the markets are facing a global pandemic and still the indices are moving northwards defying all gravity. One must understand that, Equity markets are volatile and despite the long term compounded annual growth rates (CAGR) being higher than mutual funds; everyone is unable to take the volatility in equal capacity. Risk profile of each person is different and we have discussed the same in our earlier blog on – Risk Profiling)

Like the risk profile of every person is different, the risk involved in every asset class is also different. In simple terms, the risk is completely different in equity and mutual funds.  In other words, direct equity exposure is always high risk – high return proposition. While there is a possibility of earnings higher returns, there is also a chance that the investor may end up with negative returns. Even though equity mutual fund schemes have a higher risk due to the asset class they invest in, they have a diversified portfolio. Such diversification is not possible in individual equity holdings if the invested amount is lower. On the back of diversification and the ability of fund managers to stabilise the equity mutual fund portfolios, any negative return on a single stock can get compensated by better returns generated by another stock in mutual funds.

We have discussed the two factors about taking exposure to the MF or direct equity, we are discussing the remaining factors now. The parameters like possible diversification, Research & selection process and taxation process are the parameters we would discuss in this part.

Possible Diversification – Who Scores Here?

As mentioned earlier, diversification has many benefits. A well-diversified portfolio should include at least 15 to 20 stocks, but that might be a huge investment for an individual investor. Just imagine how much diversification a new entrant can manage if he only has Rs. 5,000 to Rs. 10,000 to invest? Diversification is hardly possible in direct equity route. However, as in the case of mutual funds, one can get a diversified portfolio even if the investment is as low as Rs. 500 to Rs. 1,000. Buying units of a fund allows the investor to invest in multiple stocks without the need to invest a huge amount. The best of the fund managers in the industry are hired at no additional cost with minimal investment.

It is true that the Mutual Fund scores here, but then the portfolios are not built in a day. One may start the equity SIP and create a good diversified portfolio. Further there are certain stocks having low equity base and the institutional players cannot have an exposure. There are many winners in that space where an individual can have exposure and it turns a multibagger. Remember you just need one such play to make fortunes in the markets.

Research and Tracking – Tedious Process

One benefit a mutual fund provides is that one need not pick a stock himself. It is the experienced and expert fund manager who performs the process. In equities, picking stocks, tracking them, making sector and asset allocation, buying and selling stocks when required, need a consistent follow up and time. However, in the case of mutual funds, after selection of a mutual fund scheme (aligned with one’s financial goal), it is the duty of fund managers to carry out research and allocation. And we opine, it is usually best done by a professional fund manager.

There have been cases where investors start equity investment with enthusiasm, but eventually as the work gets tedious and returns hardly appear, they start losing interest. And the end result is stagnant portfolios. A few portfolios after a few years become so obsolete that many stocks in those portfolios that get completely defunct or in many cases hardly provide any exit route.

In a mutual fund, the investor can avoid such situations completely. It is managed by a professional fund manager who will ensure that the portfolio contains good stocks with potential for long term returns. Further, the kind of network, research capabilities, financial software and connection with company management mutual fund managers have got – individual investors would hardly get an access to such advantages. Last but not the least the performance bonuses are lined to the portfolio performance – hence the returns generation and maximisation of profit is what fund managers look at.

Again it may seem convenient to opt for mutual funds. However one must enter the equity den only if have passion. We earlier mentioned about the enthusiasm. While Enthusiasm is necessary to accomplish great work elsewhere, in equities enthusiasm only leads to disasters. To be specific, if you have passion about equities – direct equity is one can opt for. Remember, enthusiasm may fade away, passion remains.

Taxation Process – A Critical Factor

When one manages a portfolio of stocks of direct equity exposure, it is natural to churn the portfolio on a regular basis. A lot of buying and selling of equity stocks occurs. Some may be long term and some may be short term. If the selling of stocks is done within one year of purchase, there is an incidence of short term capital gains tax. However, in the case of investment in mutual funds, for a fund manager, there is no capital gains tax. Even if it were to book short term capital gains for the fund, they manage it. This comes in as benefits for investors in the mutual fund. The taxation factor comes in for mutual funds investors only when the amount is withdrawn by selling units.

Again it is more of convenience that plays a part here. Rather looking at complexities of taxation process, we must look at the Post tax returns generated by equities and mutual funds. Always keep your focus on your financial goals and the instrument through which you want to achieve that goal. If you find equity is that asset class, taxation process should not be the reason to deter you from the path. Again, it is your financial goal that should decide the exposure to instrument one should take to.

Core Competency is Important, Not Markets

Financial investment is an expert domain and hence also requires a lot of focus, time and dedication. As we stated earlier, it may be simple but definitely not easy. One may be an expert in their own field. A person may be a great tech-programmer, sales person or an expert in a particular domain. It is always advisable to stick to the domain one is an expert in and this would probably end up in the person earning more. If we try to earn from core professions along with trying our own hand on investing as well – it may not end up good. We advise the investor to leave investing to the specialists. And mutual funds investment exactly helps in that. Just imagine working out parallel on equity investment and the core profession is a difficult task. Not everyone would be able to multitask such a way.

Conclusion

The core competency factors suggests the mutual funds are a safer option for new entrants. We are not suggesting avoiding direct equity investment. Equity investment can be more profitable and worthwhile if one is willing to spend time. Time spent on analysing, tracking and researching companies and sectors. If one can handle volatility and has an adequate investable sum to build a diversified portfolio. Else, those looking to grow safely, trying to beat the inflation and higher than risk free returns, a mutual fund seems to be a good alternative. Remember, never test the depth of the river with both feet. Start an investment journey with equity mutual funds. And when one achieves a critical mass – direct equity exposure route can be adopted.