Investing in stocks needs deep understanding of markets

This article was first published on livemint.

I am interested to invest in Indian equities. Should I directly buy stocks or opt for mutual funds?

Investing in equity markets is rewarding in the long term. Indian equity markets had a phenomenal run in Calendar year 2017. Large-, mid- and small-cap indices gave calendar year returns of 27%, 47%, and 58%, respectively, in 2017. While such returns cannot be expected every year, equity investments have historically given good returns in the long term. Equity as an asset class has outperformed real estate, gold, and fixed income products in India.

However, direct investing in individual stocks requires a deep understanding of the markets and continuous involvement in investing. If you do not have the time or expertise for this, then direct investing into company shares is ruled out.

On the other hand, mutual funds are managed by seasoned fund managers. If you invest in mutual funds, you do not have to worry about stock picking and tracking the stock market.

All equity mutual fund investments are subject to market fluctuations, especially in the short term. To diminish its impact, investments should be done through systematic plans.

You should ideally invest in 3-4 funds from different mutual fund companies to benefit from the diversification of fund managers and companies. This reduces the risk from a fund manager of fund house going wrong their bets. Also, you should avoid sector-specific funds unless you have a strong opinion of a sector or industry. These funds carry higher market risk than diversified equity funds which are sector-agnostic.

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In the US, passive investing in indices has taken over actively managed mutual funds. Is it the same in India, or are actively managed mutual funds generating superior returns than Sensex or Nifty?

Unlike the US, most actively managed mutual funds in India have outperformed their benchmark indices by a handsome margin. The best mutual funds in India have been able to generate alpha as high as 10% over their index benchmarks.

If you are keen on passive investing, you can opt for index funds or exchange-traded funds (ETFs). Both index funds and ETFs are available from leading Indian mutual fund houses. While index funds can be bought and sold like other mutual funds, ETFs can be bought and sold only through a stock exchange. This makes ETFs subject to liquidity constraints. While ETFs have lower costs and tracking error compared to index funds, you need a trading and demat account to buy and sell ETF. Also, SIP is possible in index funds but not in ETF.

In spite of availability, neither ETF nor index funds have gained popularity in India due to outperformance by actively managed equity funds.

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