Stock Market VS Mutual Funds

Stocks

In the simplest of terms, stock/share/equity is an instrument that allows you to buy ownership in a company. So when you buy 100 shares of a particular company, you are basically sharing ownership in that company’s assets and future earnings with all the other people who have bought its shares. You can buy/sell stocks of listed companies on a stock exchange (which is nothing but a marketplace) where buyers and sellers decide the price at which they are willing to buy/sell those shares. The fundamental dynamics of demand and supply determine if the price of a stock goes up or down over time.

Mutual Funds

The dictionary definition of a mutual fund is “an investment program funded by shareholders that trades in diversified holdings and is professionally managed.” Huh!?

Without the jargon? A mutual fund is a product that takes money from a lot of people (shareholders), pools it all together and invests that money in financial markets with the aim to provide returns. Each fund will have its own investment objective. This defines the ground rules of where the money can/will be invested within that fund. So depending on the objectives, you can have a bunch of different kinds of funds - open/closed ended, equity, debt, hybrid, money market, diversified, etc.

Typically, the each fund will have a fund manager responsible for deciding where, when and how all the money gets invested - so long as he sticks within the parameters of the investment objective. Since the investing decisions are being taken by a person, we call this an actively/professionally managed fund.

BTW, since we are comparing stocks and mutual funds, I will use the term “mutual funds” to mean “equity mutual funds” because debt/liquid funds etc. are a completely different asset class and hence not within the scope of this comparison.

Stocks vs. Mutual Funds

So now that we have figured out what these are, the question is “which is a better investment option”?

Like most real world problems, the answer here is not a simple black or white. Both these investments have pros and cons and their suitability depends on the individual. So let’s start by comparing them across a few important criteria -

1: Returns - When we talk about investing, returns are probably the first thing that comes to mind. So how does investing in stocks compare with mutual funds? Although there are exceptions, most actively managed mutual funds are not able to provide higher returns than the benchmark index over long periods. Below is a table comparing the average performance of Large Cap, Small/Mid Cap and Diversified equity mutual funds with the Nifty 50 Index over 1, 2, 3 and 5 years (source: Moneycontrol.com).

The index has actually outperformed all three categories over 5 years. You might be tempted to say that the top 10 mutual funds give much better returns than the average fund so all you have to do is invest in the top 2–3 funds in order to beat the market. Well that is true, but only if you have a time machine. The problem is that it is very unlikely for funds to keep giving above average returns over multiple years. So the funds that gave the best returns from 2011–2016 won’t be the same that would give the best returns from 2016–2021. So unless you have a time machine in your garage, how do you pick the 2–3 “top” funds to invest in today?

By comparison, you could invest in a well-researched and diversified stock portfolio that will be able to provide better than benchmark returns over long periods of time (more on this later).

2: Risk - The second most important factor to consider is risk (some might argue that this is actually more important than returns, and they are right to some extent). Investing in mutual funds is considered much less riskier than stocks. There are 2 primary arguments in favor of this -

1. Professionally managed - It is widely believed that since an expert is making the decisions of where to invest, it is less riskier than investing in stocks on your own.
2. Diversification - A single equity mutual fund will invest money across a large number of stocks. In other words, they invest in “diversified portfolios” in order to reduce risk.

These are 2 valid points in favor of mutual funds. A lot of retail investors who invest directly in stocks are not able to manage their risk because building and keeping track of a strong, well-diversified stock portfolio requires more time and energy than most people can afford to spend.

3: Cost of investment - This one goes clearly in the favor of stocks. The only cost is the brokerage that you have to pay at the time of buying/selling. In comparison, mutual funds charge a hefty sum of 2–3% each year to manage your investments. Although this seems like a small number, but over long periods of time, this fees can accumulate into a large amount. For instance, a 2% annual fees paid over 20 years will reduce your returns by as much as 5-times your initial investment.

There are no free lunches. So the question is how much a mutual fund can charge? Is it one time in nature or regular?

There are broadly two types of charges:

1.One time charges:

Entry Load: The charges that are levied when the units are being purchased. The mutual fund would sell the unit price higher than the NAV. At present Mutual Funds cannot charge entry load.

Exit Load: The mutual fund would buy back the units at rate lower than the NAV. There are no fixed exit loads which are charged. It varies based on the scheme. The current practice is the funds could charge any way from 0.50% to 3.00% depending on the holding period. If the investors continue to hold the investment beyond the specified period, no exit load is charged.

For eg: An equity fund currently at an NAV of Rs. 72/- per unit charges exit load of 1% if the investor exits within 1 year of investment. If an investor wants to sell his mutual fund units, which were bought 7 months back the redemption NAV for such investor would be Rs.71.20/-

If the investor has sold 1000units, the total exit load applicable would be Rs.720/-. A Mutual Fund cannot use these charges for paying commission or meeting any of their expenses. This Rs. 720/ should be invested back to the fund, which would benefit the investors who remain invested for long term.

If the investor redeems after 1 year, there is no exit load.

Transaction Charges: These charges are one time charges applicable when the money is invested. This is applicable for the investments of over Rs. 10,000/-. This would be paid to the distributor/intermediary who is selling the fund.

The transaction charges of Rs. 100/- is charged for the SIP commitment of Rs. 10,000/- or above (not monthly SIP amount). The SIP transaction charges are deducted over 4 installments starting from 2^nd installment to 5^th installment.

2.Recurring Charges (Ongoing expenses/Fund Running Expenses):

The expenses are charged on Daily Net Assets of the specific mutual fund. The guideline rates are given by the regulator and Mutual Funds cannot charge more than the stipulated structure. The expenses are deducted every day from the Net Assets of the fund and NAV declared is after adjusting the expenses.

Does the expense ratio vary between funds?

There are two category of diversified equity funds offered by different mutual fund companies. Fund A has a total size of Rs. 1000crs and Fund B has a total size of Rs. 100/- crs. Does it make the difference in-terms of the total expenses charged by the fund?

Even though the expense ratio structure is stipulated by the regulator, it varies based on the size of the net assets of the fund. Higher the net assets, lower expense ratio and lower the net assets higher the expense ratio.This, in turn impacts the returns generated by the respective mutual fund. In case of funds like Liquid funds, the difference in expense ratio would be one factor.

4: Ease of investment - At first glance, investing in a mutual fund can seem very simple. You just pick the “best” 2–3 funds and simply allocate equal amount across them. But as we have seen in my first point, the hard part here is to identify the “best” fund. The human element that comes from active management of funds makes it nearly impossible to predict the “top” funds of the future!

Of course, investing directly in stocks is no walk in the park. As I have pointed out earlier, most individual investors will find it impossible to keep up with the amount of time and resources needed to manage their stock portfolio investments over long term.

In conclusion…

So just to summarize, stock portfolios have the ability to outperform mutual funds in terms of returns, the risk in both investments can be “managed” equally well, the cost of investment is much lower in stocks but the ease of investment is higher in mutual funds.