While on one side 2020 has ravaged the lives of billions of people around the world we have seen a contrary trend in financial markets.
On 23rd March 2020, the Sensex lost 3,935 points to end at 25,981 and the Nifty plunged 1,135 points to end at 7,610 points a 12.9% fall for both as coronavirus-led lockdowns across the world triggered fears of recession. These were the lowest levels witnessed since 2016. These falls however, were not long lived as the Sensex closed the month of December at 47,751 points, and the Nifty closed at 13,982 a gain of 83.7% from their respective lows.
The fall in equity prices coupled with a mandatory stay at home orders and the search for a new source of income led to a staggering rise in trading accounts both in India and abroad. Reports suggest that as many as 1.2 million demat accounts were opened with the Central Depository Services (CDSL) alone in March and April. As per CDSL’s Q2 FY21 investor presentation, new investor accounts opened stood at 4.9 million during the 1st half of the financial year and as per their Q3 FY21 presentation this number, has further accelerated to 7.7 million for the 1st nine months of the financial year with another 2.8 million accounts being opened during Q3 FY21 itself. For context the number of new accounts opened for the full financial year ended 31st March 2020 was 3.8 million.
The fact that the opening of so many trading accounts coincided with one of the worst market falls in recent memory meant that investors have enjoyed tremendous gains. In fact, unconstrained by investment mandates and guidelines fund managers must follow, retail investors free to invest in any company of their choosing (oftentimes highly illiquid and speculative stocks) actually outperformed the majority of large institutions and fund managers. A quick look at published fund category returns tell us that as on 31st December 2020, the average 1 year returns of Equity Large Cap Funds have been 12.8%, for Mid Cap a return of 22.7% and Small Cap a return of 24.9% (all returns are for a 1-year period ended 31st December 2020 and are average of the top 10 largest funds by AUM in each category). If we take this year in isolation several investors who have only recently started their investment journeys may have already generated returns multiple times this. This naturally would lead to the all-important question:
“Why should I invest with a Mutual Fund when I can generate better returns on my own and also have great flexibility to time the Market?
This is the primary argument this series hopes to address; we will of course spend time on the various investment routes such as Lump Sum vs SIP and investment types such as Direct or Regular as well as a brief overview on the types of funds.
Mutual Funds or Direct Stock Investing should not be considered mutually exclusive to each other. There is nothing preventing an individual from maintaining a portfolio of mutual funds along with direct equities. When owning a portfolio of concentrated stocks, mutual funds can provide diversification benefits and help reduce the overall volatility of the portfolio.
Now that we have got that out of the way let’s look at those people for whom Mutual Funds serve as an attractive alternative to direct equity investing. Rather than spending time highlighting the benefits and trade-offs which has already been done before, I would like to perform a quick process of elimination of those people for whom direct equity may be an undesirable option. This list may include, but is not limited to:
Individuals who may be prohibited from investing in stocks directly under their employment contract. This list may include lawyers, auditors, employees of rating agencies and also equity analysts themselves who may not be allowed to invest in stocks directly due to potential conflict of interest or possession of material non-public information.
Those people who simply do not have the required time to conduct their own research or due diligence before buying a stock. While the use of complex financial models is not necessary, it is essential to spend time researching and understanding any business before investing in it. Due to commitments such as work, or other personal reasons, people may not necessarily have the time for such research or may simply find it unattractive.
There are also several people who do not want to expose their savings to a higher volatility. They may be willing to trade higher potential earnings in turn for a lower volatility adjusted portfolio.
Finally, and as a follow up to the previous point, people may want maximum diversification benefits on a small investment value. The diversification potential of a ₹5,000 investment through a MF is far greater than had the same amount been invested in a direct stock investment, allowing you to spread your risk across a larger number of securities for the same amount.
So, by a simple process of elimination we have identified those for whom a direct equity investment may be unviable. In such a scenario, participating in equity markets through Equity Mutual Funds, becomes an extremely attractive alternative.
Let us now understand what exactly is a Mutual Fund.
What exactly is a Mutual Fund and How Does It Work?
Well, simply put a Mutual Fund is made up of a pool of money collected from several investors to invest in securities such as stocks, bonds, money market instruments etc. The funds are managed by professional fund managers who seek to produce capital gains or income for their investors.
Unlike a stock, which represents one share of a particular company, a share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding. This very fact is what gives an investor diversification benefits. As these funds may hold several (sometimes hundreds of) different securities, the fund’s performance does not solely rely on 1 or 2 securities.
The return earned by a fund’s investors can be through the form of dividends on stocks, or interest earned on bonds in the fund’s portfolio or, through an increase in the funds NAV price when the price of the underlying securities held by the fund increases (we will spend some time in subsequent articles just to understand certain terms including NAV).
In the next article we will talk about the different types of mutual funds with a special focus on equity funds.