The Mutual Fund Show: Should You Invest In Equity Mutual Fund SIPs Or Directly Into Stocks?

It’s the classic question: equity mutual funds that invest in stocks or direct investments in stocks? Here’s all you need to know.

A vehicle drives past a melted road sign in Vacaville, California. Photographer: David Paul Morris/Bloomberg
A vehicle drives past a melted road sign in Vacaville, California. Photographer: David Paul Morris/Bloomberg

Equity mutual funds in India have now seen net outflows for four straight months. And while systematic investment plan flows have stabilised in October, they’re still at levels lower than in March.

Analysts have attributed the trend to different reasons. Some said individuals who found their finances under pressure pulled their money out and stopped SIPs. Others suggested that individual investors, with more time on their hands as a result of the pandemic-induced lockdown, have been investing in stocks directly—borne out by the rise in dematerialised accounts since the Covid-19 outbreak.

In this week’s conversation on The Mutual Fund Show, Gaurav Rastogi, co-founder and chief executive officer of Kuvera, speaks about the increasing number of Indian investors that are choosing to invest directly into the equity markets rather than through mutual funds.

“Equity mutual funds... also invest in stocks at the end of the day, so effectively it’s a bet on you, yourself as a fund manager versus a professional fund manager,” Rastogi said.

So, what’s the right thing to do?

Watch the full show to know more:

Here are the edited excerpts from the interview:

Q: I would want your thoughts on how incorrect it seems that you look at your SIP returns that have been underwater for some time, you look at a favourable period for equities and say that hey, maybe, directly investing is probably better?

Rastogi: No see, that's the context and I think that's what happened. People were investing in mutual funds for one year, for two years and for three years, and there was a period between March and probably June and July of this year where your equity mutual fund SIPs would have been underwater, even if you were investing for four years, it would have been marginally break-even or underwater. You would then kind of look at those returns, would probably be a bit disappointed – you'll probably think oh my god I've been investing in SIPs, I've been disciplined, I've been doing everything everyone told me to do and still my returns are underwater, while I hear all these stories of this stock has doubled in the past three months or this stock is up 30% in the past few months—maybe it's just easier to make money in stocks.

This also reminds me of something that you have always said to me that at the end of the day, equity mutual funds also invest in an equity basket of stocks. So, the only difference between an individual investing in equities directly versus an individual investing in equity mutual funds is that in one case, in the case where you invest directly, you are the portfolio manager. You're basically claiming that hey I can select stocks and I can kind of decide when to buy or when to add more or when to kind of sell better than fund managers, or if you go through the equity mutual fund route, then of course you're basically saying that hey, you know what, they're professionals, that that's what they're paid to do, that's their day job, that's also very important. They're spending 12-15-16 hours a day doing this and we know a lot of fund managers who are very hardworking and very intelligent folks. So maybe they have a better chance of outperforming.

So, effectively when we think about this question that whether you should invest in equities or whether you should invest in equity mutual funds, we don't think of them as two different asset classes. Equity mutual funds, like you've said many times, also invest in stocks at the end of the day, so effectively it's a bet on you, yourself as a fund manager versus a professional fund manager.

But what happened in that March to June period was that the narrative was changed completely. People were, like you rightly said, looking at long-term mutual fund investments that started in 2016-2017-2018, maybe as SIPs, maybe as a lump sum, and then comparing it to recent stock market winnings, or comparing it to very favourable stocks.

Like again you mentioned, a narrative was being built on trying to show that stock selection is easy. There is a lot of anecdotal data of course and there's a lot of research data also that shows that stock selection is actually very hard. Individuals who do stock selection actually underperform individuals who invest through mutual funds or ETFs or through a professional manager. That data is very robust for the U.S. and Canada. Such data unfortunately is not easily available for India so we can do the same analysis here.

So what we did again as you've mentioned, we said let's kind do an analysis in India and see if someone had just done a stock SIP for the past three years and compare that to a stock, a mutual fund or a simple index SIP, forget any selection bias, so no one can come back to us and say, hey you chose the mutual funds that have performed well. So, let's pick the Nifty 50 index and we could have picked any other index and the results won't have changed much.

Q: So, you're effectively comparing a SIP in a set of stocks or maybe a set a particular set of stocks versus SIP in a Nifty 50 mutual fund.

Rastogi: So, we basically took about 250 odd most liquid stocks, that's the place that retail plays in the most. Retail anyway likes mid-cap and small-cap, that's what they gravitate towards more. So, we just pick that basket -- what we don't know is what an individual would have invested in -- so let's just look at that whole universe. There's a basket of about, I think 274 stocks in total, depending on which stocks moved in and out of that 250 basket. We compared that against an SIP on the Nifty Index. So, very simple and a basic idea was to make it a like-to-like comparison, where we are comparing the same time frames, the same investment amounts. So the only difference then is, how much better does an individual have to be or what level of stock picking is needed for someone to actually make a claim that if I had, instead of doing an SIP in mutual funds or ETFs, done an SIP on a basket of stocks, I would have actually done better.

Q: Can you talk a bit about that data?

Rastogi: Sure. So, let's start with what people always see, which is kind of cherry picking the data and looking at a favourable data points. What most people see and what gets the most coverage are the stocks that do well. We see that in our data as well, if you look at the top 25 three-year stock sets. So, if I look at three-year stock sets and then choose the top 25 stocks, the average return is 50.8% -- that's the average for those 25 stocks. That's phenomenal and that's the data set that people focus on, those are the stocks that are written about, those are the stocks that are in the news, those are the stocks that everyone will give you an example of.

Let’s take a very popular one, Laurus Labs. Three years stock SIP in Laurus Labs would have been up close to 90%. This is data till the end of September, so September 2017 to September 2020. The flip side of course is if you, instead of catching the top 25 stocks, you actually caught the bottom 25 stocks. This is where the risk is, this is what no one focuses on. If you look at the bottom 25 three-year stock SIPs you could have lost as much as 40.5%.

This is a stock SIP, it's very hard to have an XIRR of 40.5% in an SIP. This is possible because this is what single names do. There are stocks that go up 5-6x like Laurus Labs, there are stocks that can even go to zero, but a lot of them are down 80-90%. It is very hard to say that, you know what, I would have only picked the top 25 and not the bottom 25.

So then the third thing you look at is, you look at the distribution of the entire 274 stock SIPS that we have. What we find is that only one in three stocks have a three-year SIP XIRR, which is better than Nifty 50. So that's the kind of predictability that you need. The odds are stacked against you massively. Two thirds of the time you're going to pick a stock whose XIRR is lower than Nifty. So if you think that, you know what, I want to be my own fund manager, I want to invest in equities, I'm not saying that there's anything wrong with it. Just understand how the odds are stacked and just understand what's the amount of work that a fund manager is doing or the amount of challenges that a fund manager is facing, which you will now be faced with because you have taken it upon yourself to say that I'm going to be picking up these stocks and I'm going to beat the Nifty XIRR.

So, one in three is pretty bad odds right? Even if you look at one of the examples that we made earlier, which is Laurus Labs, how many people would have bought it? And I'm not just picking on Laurus Labs, but the pharma sector as a whole, how many people were buyers in 2017 2018 or 2019? No one knows. In 2020, Pharma did well only because there was a black swan event that happened. Covid is a black swan event whether you'd call it that or not, and Pharma just happened to be on the right side of it. Otherwise there were no tailwinds going in. So, if someone says that Pharma stocks are doing so well, since March even Pharma ETFs and pharma mutual funds have done fantastically well. but that does not mean we will be able to catch the next inflection point. That does not also mean that we'll be able to catch, two years down the line or three years down the line, which industries will be doing well or which stocks will be doing well.

Yes, there are arguments, people can say that there are some systematic ways of selecting stocks, there are factors that we can think of, quality is a factor that's been doing very well for the past eight nine years. Momentum is a factor that's been doing fantastically well in India in the past five six years. So, if you use these factors and create a portfolio, you're bound to beat the market. I hear this quite often and I tell them in 2000-2010, the only factors that worked with value was small cap in India. Since 2010 neither of them have worked.

Q: A lot of people have said that they are holding funds for the last three or four years and some of them or a lot of them are still just about breaking even. Fixed Deposits are giving better returns. Why shouldn't they choose that as opposed to single stocks or mutual funds in the first place?

Rastogi: That's, again, you started out by saying, FDs are not very good compounders. With equities and with equity mutual funds, you can build a lot of historical back test and you can say that over a 15 year period or over a 10 year period -- in India, it turns out that somewhere between 7 to 10 years is the break-even point when almost always your equity returns will be higher than your FD returns. Now, those are point to point returns but it's not a guarantee. With equity mutual funds, there is never a guarantee. So, is there a possibility that 10 years down the line your equity mutual fund returns will be lower than FD returns? There is a small possibility that it can happen. Anyone who says otherwise is just wrong. I mean, we have a very big example in Japan since 1989, they're just about close to breaking the 1989 highs right? So, it took them about 30 years to get back to that level. Of course, that was after the bombastic rally they had in the 80s. So, the point is that if you're really risk averse, if you want 100% certainty, then just for your peace of mind, FDs are good, liquid funds are good, GILT funds -- if you hold them to maturity -- are good. There are ways where you can get better returns, better tax adjusted returns, especially in terms of liquid funds versus FD because FDs are out of taxed income. That can help you, but if you look at the odds, and if you don't need the money in the next 7 to 10 years, then the odds are in your favour that you will get better returns in FD.

Now, having said that, you can't keep on comparing it every time the stock market falls. Those returns won't be higher at every point in time, that's one part of it. The second part of it that happens is, FD returns are always looked at as a point to point return and even if you did a recurring deposit because it is kind of riskless—your recurring deposit returns and your fixed deposit is roughly the same.

In mutual funds, let's take a mathematical example. Say I started my SIP 12 months ago. So, every new SIP that I'm doing today—so my 12th SIP is 8% of my portfolio. If at that point the stock market falls, my previous investments have not earned me a rate of return which is good enough or my previous investments are not big enough part of my portfolio for them to be able to manage this fall in my returns. If someone's been investing for 17-18 years, even a fall that happened in March, their XIRR would have changed by 1-2%, but for someone who has been doing a SIP for one year, their XIRR would change dramatically, almost like a fall from the index levels. So, if the index is down, 25-30% your XIRR would dramatically go into the negative from +5-15% to -10 or something like that. If someone's been investing for 17-18 years, now because they have already built a lot of capital, they've already earned a lot of returns, they've already compounded a lot of their earlier investments, every progressive fall that will happen will have a much smaller effect on their XIRR, and this is just mathematical.

This doesn't happen in FD because it is a straight line. So, it doesn't matter whether you do it as an RD return, straight line is a straight line. That also kind of bothers people and most of the time people will say I've been just investing for three years and it's still underwater and you can show it mathematically, you can even build that Excel model yourself, and it's very easy to build, and you will see that 15 years down the line, even if it's down 30%, my XIRR probably goes from 15 to 10, still better than an FD and that is in spite of a 30% fall.

Q: Now, for people who are already investing in funds and already invested in a particular category of funds called multi caps, they were faced with a bit of a surprise when the new ruling came, and then the mutual fund or the AMFI body made some representations and then another ruling came in. So, now, what's the status and what should an average multi-cap investor do?

Rastogi: So, first thing is I think most multi-cap funds will switch and rename themselves as flexi cap. This is again just our opinion. The earlier multi-cap ruling that came which said that you need 25% in small cap 25% in mid cap 25% in large cap, you only have a playing ground of 25%. In some sense, something like that actually defeats the purpose of having a category. Given that you have a flexi-cap fund now, an argument can be made that I'm actually better off buying 25% mid cap index 25% small cap index, 25% large cap index and 25% in flexi cap funds. I have roughly the same kind of risk as a multi-cap fund under the new rules, but I have just reduced my expense ratios dramatically. So, it almost feels like this new multi cap ruling is self-defeating in that sense. Our take is that most fund houses will realise that their best bet is to have the freedom or give their managers the freedom to continue to invest across the entire cap structure. So, they will rebrand as flexi cap.

Plus, there is also a practical problem right? Not all funds, especially the large multi-cap funds, can upsize their small cap portfolio to 25% that easily without affecting market prices.

If your multi cap fund does not want to rebrand itself as a flexi-cap fund then definitely think about the possibility of why not just replicate that multi cap fund under the new rulings as a 25% large-cap index, 25% mid-cap index and 25% small-cap index and 25% in a flexi cap fund?