SIP in Mutual Funds- Choose well- A case for Index investing(Th

People write in to ask whether it is better to opt for mutual fund route or direct equities route. To me, it is clear that a portfolio of well chosen direct equities will do better than a mutual fund portfolio.

As mutual funds grow larger in size, it becomes difficult for them to beat the benchmark indexes. This is because of our market structure. We do not have many large ‘market capitalisation’ companies. If a fund manager has a Rs.5000 cr portfolio, he would ideally like to put a minimum of Rs.50 to 100 crore in a single stock. So, he would look for companies that have a minimum market cap upwards of Rs.5000 crore, so that a Rs.50 cr investment in a company does not become a very large stake in the company. Here, the invesment of Rs.50 cr becomes a one percent stake in the investee company!

There are only around fifty companies that have a market capitalisation of over Rs.40,000 crores! So, if an FII were to want to put $ 10 million in a single stock, they would like to look at a company of at least a billion dollars in market capitalisation.  So, as investment vehicles become bigger and bigger, there is a compulsion to invest in the biggest companies and most large mutual funds start looking like each other. And they cannot ignore any stock in the index, for fear of not conforming to the herd.

Due to this lack of depth and breadth in the market, a highly focused quality portfolio of five to ten companies can do better than the NIFTY or Sensex. 

However, not all of us can spend time. Apart from this, there is another big handicap when we want to invest in direct equities. For example, if we were to pick a high quality portfolio of ten stocks, we may need a minimum monthly investment of around Rs.50,000 and upwards as a SIP commitment for ten years. Not all can afford this. So, the choice of direct equities through an SIP route, is closed if we cannot write this size of a cheque every month. And we need to have five to ten stocks rather than pick just one or two stocks. A minimum diversification is needed to insulate the shock of a single company investment going under for unforseen reasons or through a structured fraud.

A mutual fund route is good for those whose investment sizes are small to moderate.  Choosing a mutual fund thus becomes more important, though everyone says they have the same benchmark, they seem to invest in similar or same stocks.

A five year return (as of 20^th June 2015) on an annualised basis is given below:

1.     MFs that invest in Large Caps- Best return was 15% and the worst was 7.5%;

2.     MFs that invest in Multi Caps- Best was 20% and worst was 9%;

3.     Banking sector funds- The best was 17% and the worst was MINUS 1%.

4.     The NIFTY/Sensex return was around 9%.

5.     The Liquid Funds returned around 8.5% !

This clearly shows that there is a huge disparity in performance between professional money managers who are paid to manage money on a full time basis.  You could trust any one of them, but the returns are not going to be predictable at all. The disparity is surprising given that all of them have expertise in investment management and have equal access to information and research. We do get a lot of statistical tabulations on mutual fund performance and there is no assurance that if someone topped the charts in the past, he will do it in future. There is unpredicability of performance going forward, irrespective of what measures we use.  So, it becomes important to diversify amongts mutual funds, in order to hedge ourselves agains weaknesses of the investment managers. Portfolio diversion does not happen since most mutual funds look like each other in terms of top holdings etc.

Thus, mutual fund investment through SIP routes do not guarantee us market returns. Going by available data, there is a fifty percent chance that the fund we choose may do worse than the market. In such a case, if we want to be sure about being as close to the market returns, the best option is to choose an Exchange Traded Fund (ETF) on the Sensex or NIFTY.

To sum up, if you are not confident about picking stocks, it is best that you stick to the mutual fund route. And if market returns are what we are looking at, it is better to stick to an ETF.  I am not a big fan of sector funds and there is a lot of timing involved in picking those up. Maybe an FMCG sector fund or a MNC sector fund will always do well, but there are no guarantees.

 (This piece appeared in today's Deccan Chronicle)