Mutual Funds Day 5: Advantages of MF over Active Investing
Mutual Funds were there from the start, but they became famous only after the Vanguard Group launched their passive schemes. The main reason their offerings became popular was due to lower fees & transaction costs.
Earlier on people preferred to invest directly by buying stocks a.k.a. Equity. The advantage of Equity is that there are no charges levied as there are no fund managers. You become a part owner of a company directly and either get a dividend or capital appreciation if the company does better.
The downside of equity is that, if the company underperforms there is a risk of capital loss. No one can say with 100% certainty which firm will outperform in the future. Some firms go Big and some go Bankrupt. If you had invested with the right company at the right time, you would have made tons of money.
Most likely an individual investor has a limited source of capital. So he may not be able to buy an adequate quantity of shares of multiple companies. The best he could do is buy a sizeable amount of 4 to 5 companies and sit on it. He can only hope those companies may outperform in the future and his capital will grow 5x,10x, or 30x.
Mutual Funds on the other hand is a Trust. A group of well-educated people manage a pool of funds and then buy or sell shares of companies. This is a perpetual process. And unlike individuals, the mutual fund houses do not pay taxes or charges for every buy/sell transaction.
Over a period these Mutual Funds would have removed the laggards and added the winners to their basket. So unlike direct Equity, the chances of a capital wipeout are lower. Your capital is spread evenly across multiple stocks to avoid a huge capital loss. Usually, an MF may have 20 to 40 stocks in their portfolio.
There are 2 disadvantages for MF.
- A fund manager will take a profit share: Usually up to 2% for managing your funds.
- Outsized returns are ruled out as there is no stock concentration.
If you are very good at Equity Research and have a special eye for spotting multi-baggers i.e. stocks that could return 10x or 20x over a period then direct equity investing is the best way forward.
On the other hand, if you are a working professional, business owner, self-employed, or not that keen to do stock research then Mutual Funds are the way forward.
The main difference between the two approaches is the engagement of labor. In the first case, there is an active labor and you get results as per your merit. In the second case, the results are from passive labor and this means the returns you get from MFs are not directly related to your effort & time.
Ideally, you should be spending time & effort on areas that will give you the best bang for your buck. If you are a good Engineer and you earn Rs10,00,000, whereas your investing skills fetch you Rs50,000 per month — then it makes sense to make Engineering your active labor and outsource investing as passive labor.
You can think of the “Fund Manager” as an employee managing your funds. You are entrusting him to handle your investments and that means it comes at a cost.
An employee is usually paid a fixed salary + incentives for the work. But in this case, the payments are a fixed percentage. Usually, Fund Managers charge up to 2% per year for active management.
The surprising fact is that even if the Mutual Fund gives you 40% returns or minus 20% returns, the fund management fees will still apply.
It is also crucial to know that the risk and returns from Mutual Funds are on the investor (you). The Fund Manager has no perceived risks or returns directly, but he will definitely be incentivized to generate above-average returns to keep this job.
The fund manager has a crucial role to play as the assets are purchased/sold as per his decision. If you are a DIY investor, then you need to take extra caution to study the background. In case you are buying MFs via a Financial Advisor, then it is likely that they would have done the due diligence.
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