Most investment advisers recommend an equity exposure in order to create long term wealth. We could'nt agree more with them - historically, stock-specific investments have outperformed all asset classes over long time horizons. But most of these advisers almost unanimously advocate the equity-oriented-mutual-fund route to gain exposure to equities. We have a slightly divergent view here. ProsperoTree.com will provide you 4 pertinent reasons to invest directly in specific stocks vs. investing through equity-mutual-funds.

1. Mutual Fund Fees reduce your Effective Returns

Mutual Funds incur numerous costs - fund managers' fees, research fees, marketing & distribution costs and several other administrative costs. It is very natural that since you become a passive investor in the mutual fund route, the fund house will charge you fees for the service they render.

The 'expense ratio' of a scheme i.e. the fees charged to investor typically ranges from 2% to 2.5% of the Assets Under Management. Simply put, if your returns from a fund are 15% then post deduction of 2.5% fees, your effective returns would translate to 12.5% (ignore the taxes and transaction costs for the sake of illustration). On the contrary, if you were to find a good investment adviser who advises on stock-specific investing, the chances are that his fees would be less than that of mutual funds.

2. Exit Loads in Mutual Funds could Lower your Effective Returns

Exit load is an amount collected when an investor leaves a scheme - It is generally a way to penalize an investor if they exit before the stipulated holding period. Several Mutual Funds typically have an exit load of ~1% if mutual fund units are redeemed within 365 days of investing. Just like expense ratios, 'exit load' too dent your effective returns. However, the exit load can be avoided if one's holding period exceeds the scheme's minimum threshold.

3. Size Matters - Mutual Funds may NOT Invest in Companies with Small Market Cap

The very nature of Mutual Fund industry limits their ability to invest in relatively unheard of small cap companies. Surprisingly, even the 'Small-and-Mid-Cap-Oriented-Mutual-Funds' will voluntarily or compulsorily play safe and avoid the small cap companies in their early stages of growth as it may prove to be a risky bet.

We would like to highlight here that several companies that have become multi-baggers today, were not-so-popular small or mid cap companies a couple of years ago. For instance, Page Industries (popular for Jockey brand) was trading at around Rs. 300 levels circa FY07 with a market cap less than Rs. 500 crores while it is trading at Rs. 15,000 levels circa FY15 with a market cap of Rs. 16,000+ crores - A ~50x bagger in 8 years! Not-so-surprisingly, most Mutual Funds treated Page Industries as untouchable back in 2007 but started accumulating this counter only once it would have become a hot stock when it would have already rallied significantly. Investing through mutual funds increases the likelihood of missing out on the initial super-normal growth phase of a company when its stock delivers extremely superior returns.

4. Liquidity Matters - Mutual Funds may Ignore relatively Illiquid Stocks

Just like the company size, Mutual Funds are also limited by the liquidity of the stocks. If low volumes of a stock are traded on the exchanges then Mutual Funds would be averse to investing in those stocks as it may become difficult to exit such stocks. Typically, the small cap companies mentioned in the previous point would be relatively illiquid. So again, through the Mutual Fund route, an individual investor stands to lose the chance of entering a potential multi-bagger in its initial super-normal growth phase.

As an illustration, ISGEC traded at price of Rs. 1,000 in FY14 and daily average traded volume was less than 1000 shares. Most mutual funds chose to stay away and entered it only when the price touched Rs. 2,400 and traded volumes improved in FY15.

(We had recommended ISGEC in March-2014 at a price of Rs. 950 - Rs. 1,050 which is now trading at ~Rs. 5,500. You may read the stock update on ISGEC here - 3rd Report on ISGEC).

ProsperoTree.com View

An investment adviser who does not have stock-picking skills will certainly advocate the mutual fund route. While this is surely better than not investing in equities at all, ProsperoTree.com recommends that you put in some hard work to find a good investment adviser and invest directly in stocks. You can also read our individual Stock Investing Ideas here - Investing and Stock Trading Ideas here - Tipwala.

PS - Mutual Funds in this entire article imply equity-oriented-mutual-funds.

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