Mutual funds vs direct equity: Which is the best way to invest?

At Berkshire Hathaway’s annual meeting in 2021, Warren Buffett gave us a sweet and short answer – “I do not think the average person can pick stocks.”.

He went on to point out that none of the top 20 companies by market cap in 1989 were in the top 20 today. Even in one of the most attractive sectors of the 20th century – automobiles, there were over 2000 defunct companies. In fact, after the 2008 meltdown, there were just three left; of which two had been rescued from bankruptcy by the US government.

In a world where everyone is super bullish on tech, EVs etc., this is a sober reminder.

He backed his age-old recommendation for retail investors to simply invest in a S&P 500 index fund, saying – “…there was a lot more to picking stocks than figuring out what’s going to be a wonderful industry in the future.”

On the other hand, you have discount brokerages and crypto exchanges spending really expensive ad dollars telling you the opposite. This will be backed up by your friends and neighbours who would have (or at least will claim to have) made a killing trading directly in stocks and cryptos over the last year.

Ultimately, it’s a judgement call. My personal view aligns with the one who has returned 20 percent annually over the last 56 years.

The underlying reason is that human beings are basically hardwired to make poor decisions, when it comes to the stock market. Human beings are, by definition, average because their “gut” or style of investing works in certain market cycles and doesn’t in others. Further, humans are all susceptible to the fallacies of bias and emotion.

This has been researched extensively and well laid out in books like “Thinking Fast and Slow” by Daniel Kahneman, who won a Nobel Prize in 2002 for his work on behavioural economics.

In fact, even a majority of “experts” are not able to defeat these biases as explained in the following excerpt from the book:

“Mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.”

So, how would you actually go about it? Broadly, for an average Indian investor, I would first bifurcate equity exposure in three categories – large-caps, mid-/small-caps, and international. The first two allow for different risk return profiles within the Indian landscape. International exposure provides further diversification, away from India-linked risk.

I don’t think active managers can reliably generate alpha in the large cap or international space. Over the last 5 years, 83 percent and 73 percent of active large-cap funds in India and US respectively have underperformed their benchmarks. For large-cap exposure, I would consider a Nifty 50 ETF/index fund and a Nifty Next 50 ETF/index fund. On the international side, I would pick a couple of ETFs/index funds that just track the NASDAQ 100 and S&P 500. While picking an ETF or index fund, one must make sure you are looking at AUM (assets under management), fees and tracking errors.

For small- and mid-caps, I think there is still some scope to pick active mutual funds. Research on the fund manager’s track record, relative performance against peers and the benchmark, and fees is important. This data is widely available. Also, if you have a financial advisor or have some experience with investing, direct plans (vs. regular plans) will make sense since they usually charge around half the fees of regular plans.

Trading in stocks can be a lot of fun, and that’s all one should expect from it. Don’t mistake luck for skill; that can prove to be really costly in the long run.