COLUMNISTS
STOCKS
MUTUAL FUNDS
NRI TAX
INDIAN TAX
INTERVIEW
PERSONAL FINANCE
PERSONAL BANKING
INSURANCE
REAL ESTATE
GOLD
CURRENCY

Mutual funds vs stocks

Murali Iyer

A friend of mine, T R Ramji, has this irritating habit of ringing me up during the peak hours of the working day to find out about the state of the stock market. Give him a tip, and he would happily go and snap up a couple of thousand shares of the recommended stock, provided the price is below Rs 300. Higher the price, the lower would be the quantity purchased. His knowledge of stocks and market movement is abysmal and he is over-dependent on people like me to suggest good buying opportunities, and also the timing of entry and exit.

Although he has made good money in this bull run, he would be one of the first victims when the market goes into a tailspin. Recently, he got a trade confirmation from his broker 15 days after it had been executed. And it was not the scrip that he had asked to be purchased. Luckily for him, the price of the scrip had moved up.

Like the example above, a lot of people get into trouble due to their lack of knowledge of the stock market. They ask me whether they should put their money in mutual funds. Although I advise people like Ramji that they are better off by letting professional fund managers handle their money, I find it very difficult to really answer this question better. Being a hands-on investor myself, I find it insulting to think of putting my money in mutual funds. But I also realise that not everybody has the same appetite for risk-taking as I have. And who knows, with the passage of time, even my appetite for risk-taking might go down as I have seen it happen with my father.

Mutual funds have been advertising their spectacular returns, on the back of a strong bull market. People have also been entrusting the onerous and antacid-recommended job of portfolio management to professional fund managers. As I have been also advocating investment in mutual funds for the small investor in my earlier columns, and also privately, my views still remain the same. But let me hasten to add: "To each his own". Sometimes, the returns fetched by a mutual fund make me go green with envy on a particular week when that fund's net asset value (NAV) has been declared positive against my losses. But on the flip side are those days when I snigger derisively at mutual funds as I laugh all the way to the bank after having punted successfully on some stock.

So which side is the bread buttered?
Mutual funds have definite advantages in that they have access to something very important in the market - information. An army of financial analysts spread across a wide array of brokerage houses feeds them information by way of condensed reports, which have been arrived at after having gone through mountains of data. After sifting through this voluminous data, the fund manager is at a liberty to choose his picks, while a lay investor finds it difficult to even get hold of a decent annual report of the company he wants to track. The hottest tips are also fed to the fund manager, while you and me get to know of it after the scrip has skyrocketed.

Besides brokers and analysts, the managements of various companies also aggressively woo the fund manager. While you and me might find it difficult to get our pertinent question answered at the annual general meeting (AGM), the silliest of queries from a fund manager will elicit a detailed presentation by the top management of the company. This is due to the fact that the fund manager's actions can make or mar market capitalisation. Due to their sheer size and scale of operations, mutual funds also have other advantages such as lower transaction costs, greater bargaining power and infrastructure.

Be that as it may, there are a lot of "Doubting Thomases" as far as mutual funds are concerned. Another friend of mine, Suresh Iyer, studying in Australia, pointed out that almost two-thirds of the mutual funds in the US have underperformed the Dow Jones Index for decades.

Disadvantages of mutual funds
Why do mutual funds have such a poor long-term record? Size is their greatest strength and their greatest drawback too! A large corpus limits the investment sphere for a mutual fund in the same way as a small fund limits the universe of an individual investor. A large corpus limiting the investment sphere can sound surprising to many. But the fact remains that a fund with large investments will become unwieldy, and hence, unmanageable.

A typical fund would limit itself to around 50 stocks in which its investments would be spread. Thus, a Rs 100 crore corpus would ideally see Rs 2 crore being invested in each scrip. There are cases where a fund comprises more scrips too. Further, regulations prohibit a fund from owning more than 5 per cent of a company's equity. This limits the fund's buying power to highly capitalised scrips.

Again, as one considers companies with large promoter holdings and loyal long-term investors, the actual floating stock comes down still further. Thus, liquidity (also a measure of risk) and depth are two factors that are paramount from a fund manager's perspective.

In the Indian context, this narrows down the potential stocks to about 500 large- and medium-cap stocks put together. The other stocks do not find favour with the fund manager even if it turns out to be a potential multibagger. This is due to the fact that a fund manager will not be able to buy a large chunk of stock to do justice to the fund's corpus.

A lot of funds missed out on the initial boom in software stocks as the market capitalisation of these stocks was very low at that point of time. Moreover, mutual funds being governed by a management team, it becomes difficult to latch on to a good growth story during its budding days. This is irrespective of the price or market capitalisation or even the liquidity being high or low. By the team the management team gets convinced and gives the green signal to the fund manager, a large part of the story could have got out of hand.

What do you do?
So the million-dollar question is: "Should you favour mutual funds?" It would really depend upon an individual's preference. If you are the risk-averse type, are into a job or a business, have little time to track stocks, commodities, industries and trends, all that you need to do is to fill out the application form of mutual funds and let the fund managers take charge.

But if you like a little excitement and also have the time and inclination, then you might be able to beat the fund manager at his game. After all, he is also as human as you and me. But, beware! This will be a near full-time occupation and it could also be frustrating. As I have said earlier, it could also make you reach out for the nearest bottle of antacids fast.

But if you are a perennial fence sitter, then it would be prudent to invest a portion of your investable money in mutual funds and play around with the rest. The proportion of investment in each, what avenues to seek, which stocks to latch on to and when to discard, are all factors depending upon an individual's propensity for taking risk. This, in my opinion, is the key to defining your investment goals or setting your agenda. But, if you are the type who wants to match his wits with a fund manager, remember: "Fund managers have as much a herd mentality as a small investor."

Personal finance

Tell us what you think of this feature