One of the common, yet very difficult, choices that investors have to make is whether to invest directly in equities or through equity mutual funds. Frankly, there are no clear answers. There are 7 broad criteria based on which you can make a choice; whether you want to buy equities directly or go through an equity mutual fund..
Can you spend the time to track equities?
Investing in equities is not just about buying equities based on tips and investment advice given. It is also advisable to conduct your own analysis, ask the right questions and also monitor the portfolio. If you believe that you can spend the requisite time and have the bandwidth to do all that then you can seriously look at investing directly in equities. Then there is the issue of skill-sets needed when it comes to selecting equities and in monitoring them. Remember, you do not just need to understand the stock, but the company behind the stock and also the dynamics of the industry and the environment in which the stock operates.
Do you have a large investable surplus to spread your risk?
Investment is all about spreading your risk and that is normally done through diversification. But that entails a bigger investable capital. If you need to meaningfully spread your investment portfolio across 10-12 stocks with economies of scale, then you are surely looking at a big investable surplus before you can directly start investing in equities. Mutual funds manage money on behalf of thousands of investors and are in a better position to spread the risk. As a fund-holder, you indirectly get the benefits of diversification through your proportionate ownership in the asset base.
Are you looking to buy a few stocks or also invest in larger themes?
If you want to focus on a handful of stocks that you understand then direct equities may work perfectly well for you. But what if you are looking at participating in larger themes in the market? For example, you may want to participate in the re-rating of consumer stocks or you may want to participate in the India story by buying up banking stocks. Alternatively, you may want to buy the market as a whole; something that can be done very easily by buying an index fund. If you are looking at bigger themes with smaller investment allocation, mutual funds may be the answer.
Are you looking at building blocks to long term wealth creation?
Investors often argue that just you can do an SIP on mutual funds, so also you can do SIPs on equities. That is where stock selection becomes very critical. For example, if you had consistently created an SIP of real estate stocks or capital goods stocks in the last 10 years then most likely you will be sitting on negative capital value. The story would have been very different and positive if you had done this SIP on automobiles or private banks. A much easier method will be to undertake this SIP through a diversified mutual fund. You have enough empirical evidence to substantiate that an SIP on equity funds works effectively and with much lesser hassles.
Are you looking to sync your investments with your long term goals?
Normally, you do not buy equities or mutual fund units in isolation. They are part of a larger investment plan and help you move towards your long term goals. The bottom-line is that if you are looking at a serious sync with your goals then mutual funds work better. Your long term financial goals are largely based on sound risk management and that can be better achieved through mutual fund investments as there is a natural diversification built into them.
Are you looking at tax efficiency over a longer period of time?
This may not be too important a question for a small investor but as your investment size starts getting bigger, it begins to matter. For example, if you are looking at direct equities and equity mutual funds from the capital gains point of view there is not much of a difference. Both equities and equity mutual funds are required to pay zero tax on LTCG and 15% tax on STCG. However, there is a subtle difference when it comes to dividends. Dividends beyond Rs.1 million are taxable in the hands of the investor in case of equities while there are no such limits in case of equity mutual funds. This can become a critical issue as your portfolio size builds up. Similarly, if you invest in ELSS schemes of mutual funds, you get an additional rebate under Section 80C, which is not available in case of direct equities. While these are all minor issues, they surely add up to quite a bit in the final analysis.
Do you think that your investments are best left to the experts?
At the end of the day, investing is a highly specialized job. The dynamics are just too many and it is an area that is in a constant state of flux. Even veteran investors find it difficult to manage their equity portfolios in such a fast-changing environment. If you are not full-time into equities, then directly equities may not give you substantially better results than relying on equity funds. The choice may be quite clear in that case to opt for the comfort and peace of equity mutual funds!