Real Returns. Can you do better than mutual funds?

Does do-it-yourself (DIY) investing work better than going to mutual funds? That’s a question many investors are asking of late. Many seasoned individual investors in the Indian market claim to have soundly beaten popular equity funds. Their claims are not difficult to believe if you look at the stellar show from some stocks.

Stocks beat funds

Looking back at the Nifty 500 constituents today, you can find as many as 205 stocks that have delivered better returns than the average multi-cap equity fund in the past 10 years. These stocks have delivered a CAGR (compounded annual growth rate) of 15-75 per cent since August 2008, while the average multi-cap fund has managed 14.5 per cent.

There are 100 stocks in the Nifty 500 list which have risen ten-fold in 10 years. In contrast, the best-performing multi- or mid-cap fund has only gained six-fold. An investor who bet just ₹10,000 on Symphony would be sitting on a cool ₹27 lakh today. Bajaj Finance has seen a ₹10,000 investment grow to ₹23 lakh in 10 years. Relaxo Footwear has delivered ₹19.8 lakh to investors who put in ₹10,000, and Eicher Motors would have gotten you to ₹10.4 lakh.

Given that professional fund managers have at least the same opportunity to identify blockbusters as individual investors, does this mean that they aren’t great at their job?

Not really. Many of these stocks did figure in mutual fund portfolios from time to time, though long-term fund returns don’t reflect this.

Why funds lag

So why do some DIY portfolios manage to beat equity funds?

One, timing is key to great returns from stock investments. But in the open-end structure, the bulk of retail investors in mutual funds pour in money only after they have seen three continuous years of high returns. Thus, fund managers are often forced to buy stocks when the markets are over-heated, and liquidate them when markets are ice-cold. As an individual investor, you have the liberty to load up on stocks when valuations are rock-bottom.

Two, while an individual investor can own any exposure in the stocks he finds promising, mutual funds are restrained from doing so by SEBI’s investment rules.

SEBI imposes a 10 per cent cap on individual stock exposures. This effectively means that even if a fund manager finds a sure-shot bet for his portfolio, he has to restrict his holding in it to 10 per cent.

He also has to book profits every time the stock performs and overshoots the 10 per cent limit. In contrast, a DIY investor can simply let his winners occupy larger positions in his portfolio.

Three, given the lack of depth in the Indian market, investing in stocks that fall below the top 200 or 250 in the market carry both liquidity risks and impact costs for institutional investors, just as in mutual funds.

The individual is free to fish for value in smaller, under-researched stocks.

Finally, creating real wealth in the stock market requires you to not just buy the right stocks, but also hold them for years at a time. Many of the blockbuster Nifty 500 stocks listed above suffered through some quarters of poor earnings, and a year or two of poor stock price returns.

Now, because equity fund managers in India are constantly held to account for their six-month, one- and three-year returns, they struggle to hold on to an underperforming stock for long, despite conviction. An individual investor is accountable only to herself and can afford to be patient.

DIY difficulties

So, why shouldn’t everyone take the DIY route? Well, they would suffer from the following constraints.

One, given the limited resources and knowledge at their disposal, individual investors have a far greater chance of getting their stock choices wrong than professional fund managers. Buying stocks such as Symphony or Bajaj Finance seems like an obvious choice only with the benefit of hindsight. If you were looking at the Nifty 500 basket 10 years ago, you may just as easily have picked Suzlon Energy, Bombay Rayon or Bhushan Steel, which have lost 80-90 per cent of their starting value in the same period.

Two, even smart investors often fail at controlling their behavioural traits during market extremes. You need considerable control over your emotions to buy when there’s ‘blood on the street’ and sell when the going’s great.

Three, the decision to hold on to a stock is infinitely more difficult than buying it. Ups and downs of business cycles, intensifying competition, disruption from technology or regulation and sudden governance risks, can all test your conviction. Analysing such imponderables and regularly checking in on company results call for not just knowledge and skill, but also considerable spare time to devote to your portfolio.

Today, most individual investors who have a full-time job or career to pursue will find it hard to manage a successful DIY portfolio, even if they are skilled.

A good compromise would be to rely on mutual funds to meet your basic financial goals and use direct equities as the icing on your cake for wealth creation.

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