The 2021 Equity Investor — How to think about the various equity investment options?

This article talks about how a new-age investor should/can approach equity investing with the plethora of products out there. I have tried to dive deep into the hurdles that new investors face and look comprehensively into the different strategies of entering the market — Mutual Funds vs Small Case vs Index Investing vs DIY.

Debashish has recently received a job offer from a popular law firm after graduating from a well-known Law School in Sonepat. As he celebrates this momentous occasion with his close friends, he cannot help but notice conversations steering themselves towards the Stock Market. His friends are keenly sharing their experience in the Market and talking astutely about their stocks, some of which they claim have doubled in the past 6 months alone! Ecstatic and newly educated about this money making phenomena, Debashish pledges to invest 50% of his salary into the equity markets that night. He starts counting the days to his first ever pay cheque and as he nears the date, he is unable to make sense of the euphoria surrounding him. The conversation at the party seemed alright but now he is actually confronted with the big question — how to invest money in the equity markets and more importantly, where to put his money? His well meaning friends tell him that the market seems to be trading at an all-time high and investing at these levels might leave him with a 20–25% drawdown. Debashish is confused. To unwind and take time off, he decides to watch the hugely popular Indian Premier League which has just resumed for its second phase after it was temporarily suspended due to an outburst of Covid-19. Throughout the match, all he can see is sprinkling of ads that talk about financial products. Some ads talk about how Mutual Funds Sahi hai whereas others harp on about trading strategies that can enable a doosri salary through the market. He also comes across multiple ads of Crypto exchanges, new age savings accounts, balanced-advantage funds etc. The match leaves him even more confused than he was before since he now has a plethora of products in front of him and a fresh salary cheque waiting to be credited to his account. He tries to reach out to a family friend who has been in the market for a long time and the friend educates him that the stock market is no 6-month money doubling machine. Over a long period of time, one can expect it to deliver double digit returns, that too, if one chooses a careful strategy. The friend suggests that Debashish do some reading into equities and Index Funds and also recommends this new product for people with a smaller capital base called Smallcase. In a matter of 4 months, Debashish experiences what most new investors are going through at the present time.

Whether you are a young investor looking to enter the markets with your new salary or a parent convinced by their children that Fixed Deposits cannot beat inflation, navigating the currents of the equity market can seem confusing. Don’t worry! This article is supposed to help you try and understand the possible options that you have as an equity investor and how best can you invest your funds into the Market. We will look comprehensively at Mutual Funds Vs Index Investing Vs Small Cases Vs Do it yourself and try to understand the pros and cons of each strategy. Please note that this article is only for people investing with a long-term horizon in mind (i.e greater than 3 years) and does not evaluate short-term trading strategies or investments in Cryptocurrency.

First things first

Try to better understand yourself. Once you understand yourself, there is a better chance of you understanding the market. Spend some time trying to figure out what your core is in terms of your ability to take risk and tolerance to volatility. There is absolutely no right or wrong here. Please also note that your risk tolerance is not related to your returns at the end of a long enough time period. While many like to believe that ‘Risk Hai toh Ishq’ hai, there is little evidence to support that claim in the financial markets. In fact, the Nifty Alpha Low Volatility Index beats most other indices and actively managed Mutual Funds over a period of 15 years (Apr 2005 — Sep 2021) with a whopping 19.1% annualised returns. The Nifty50 flagship index in comparison has only returned 13.8% in the same time period. Not every investor has to behave like an F1 driver. The race here is against our fears/emotions and we ride along with our convictions. If you understand this, then choosing any instrument becomes easier based on your goals.

Kya Mutual Funds Sahi Hai?

To understand what Mutual Funds (MF) are and how they work, I suggest you read this primer which explains the MF industry inside-out. There are multiple equity linked Mutual Funds in India and it is one of the most widely promoted financial products in our country. According to AMFI (Association of Mutual Funds in India), the total AUM (Assets Under Management) of the Indian Mutual Fund Industry stood at Rupees 36.59 trillion as on August 31, 2021. The total number of MF accounts as on August 31, 2021 stood at 10.86 crore. The number indicates that 10% of the adult Indian population routes their money to the stock market through Mutual Funds.

The choice for you as an investor never gets easy. There are multiple kinds of Mutual Funds and all of them make different promises. Based on your goals and risk profile, you should choose a MF that works best for you. There are multiple websites with tons of information on Mutual Funds. Moneycontrol is a useful website to compare performance of MF’s in different categories and across time frames. I suggest you take a stroll along the MF section of the website to get a flavour of Mutual Funds.

Bonus tip: Read all the information boxes since they explain what the terms mean.

Example from Moneycontrol Website

Should you take the Mutual Fund Route?

1. If you have no experience in the market and want to expose your income in a passive way.
2. If you want to stay away from the vagaries of portfolio management and equity research.
3. If you want to save on taxes. Read more about Equity Linked Saving Schemes here. They can be a great tool for tax saving and generate an alpha over the returns provided by Provident Funds and the National Pension Scheme with a lower period of lock-in.
4. You have a limited corpus.
5. You want to get International exposure with limited Capital.

Bear notice that past year’s performance is no marker of the performance to come in the future. Many investors look at recent performance only to get caught up in the wrong MF. Be sure to check performance over a longer time duration. Check the sharpe ratio which gives you a picture of your returns adjusted for risk.

As an example, if you compare most MF’s returns over the past 1 year or three years, they look very good because of the massive rally since March 2020. But if we remove the 2 years and compare from January 2010 to January 2020, the picture looks different. Probe everything and don’t take absolute short-term gains on face value.

The two exhibits below show the difference in returns over a longer time period compared to a shorter time period.

For complete results of the below two tables, open:

• Results over shorter time frame
• Results over longer time frame

The above two tables clearly show that over a longer time-frame before the rally of 2020 started, even the best performing Large Cap fund generated an annualised return of 14.40% over 10 years. This number might seem less to any person who started investing after 2020 as the market has been more than kind. However, it is a timely reminder of what one can expect in the market over a longer time frame.

If your investment horizon is a long journey via a bicycle, and your goal is to generate the best returns over a long period of time — investing in Mutual Funds is like paying a professional to ride your cycle while you watch from the sidelines. Speed is uncertain. Direction is more or less certain based on historical performance.

Index Investing

Index Investing is a way to invest in a basket of stocks based on a fixed set of criteria or a factor(s). Through the Index, one can get exposure to the market without actually keeping track of the individual stocks. Many people in common parlance say that the ‘market’ is up or down. What they simply mean is that the NIFTY50 index which comprises the top 50 companies of our country based on Market Cap has either gone up or down. So, the next time somebody refers to the ‘market’, you should know that they are simply talking about the top 50 stocks by Market Cap in our country and not any magical creature.

The NSE website itself lists 27 strategy based indices. These can be based on any strategy that is pre-defined and laid out. For a complete understanding of Factor-Based investing and understanding what factor is best for you, refer to this article. While many investors — old and new — are under the impression that the best way to play the market is through taking a position in the NIFTY50 or the NIFTY100 which tracks the top 50 and 100 companies of our country respectively based on Market Cap; that is far from the truth. As the linked article shows, the NIFTY50 ranks 13th in terms of annualised returns over a period of 15 years from Apr 2005 to Sep 2021 with a CAGR of 13.8%. Compare this with the top performing factor-based strategy which has given a CAGR of 19.9% over the same time period.

Index Funds give you the luxury of being away from the everyday hustle and hassle of the stock markets. The world over, Index funds have beaten a majority of the actively managed funds over a long period of time. The key here is to be disciplined in one’s investing approach and stay put for a considerable period of time, preferably a decade or more.

While Index Investing does not make for spicy conversation, it definitely delivers the returns over a long period of time. The first step as always is to understand yourself. If you have a long enough time frame in mind, be sure that you will beat most of the buzzing funds. This might not happen tomorrow or in the next 6 months, but patience is your friend in the index race.

Fun Fact: The legendary investor Warren Buffet entered into a public bet worth a million dollars against the hedge fund Protege Partners LLC. Warren challenged that the hedge fund industry would not be able to outperform the S&P 500 Index net of fees and costs over a 10-year long period. Warren won the bet as the co-founder of Protege conceded early defeat in the year 2015. He was quoted as saying “for all intents and purposes, the game is over. I lost.” One must note that Warren is an active investor himself and yet he advises most people to take the index route.

Coming back to our cycle analogy — Index investing is like sitting on the sidelines and betting that the riders may come and go, but the cycle journey will go on.

Volatility i.e. speed of returns can be uncertain but the direction is certain over a long enough time frame.

SmallCase Investing

If you have been following the market news over the past 12–18 months, it is quite possible that you have come across this term called a SmallCase. You must be wondering what a SmallCase is and why is it important for you?

A SmallCase is a financial product that allows you to buy a curated basket of stocks at a fixed fee/subscription fee in one click and rebalance based on updates from your portfolio manager. You can also create your own SmallCase and invest in it periodically in a systematic fashion.

How is a smallcase any different from Mutual Funds? Read the following article that explains what a smallcase is and the things you must consider before buying one.

In a nutshell, it is a more user-friendly product that allows you to own stocks in your Demat account as opposed to a folio in the case of an MF. A SmallCase involves actively making changes based on the rebalancing instructions which come with the perils of transaction costs, slippages and short-term capital gain taxes.

Like all new-age technology platforms, smallcases will catch your eye if you are used to a smooth user experience. With a lovely dashboard and one-click changes, you are likely to be drawn to the products on offer. The number of products on offer is increasing at a fast rate as industry leaders are coming up with new products for the community. As with Mutual Funds, beware of making your decisions based on short term returns. Make sure that you check the returns net of costs. At a bare minimum, the small case must meet your cost for the year to even be worth your consideration.

Our take is that SmallCase offers an exciting and fresh way for investors to enter the equity markets. If one wants to have a flavour of being actively involved while also being hand held, then this might just be the perfect product for you.

It is also a great tool for investors looking for a middle road between doing it themselves and going after mutual funds. Most Mutual Funds have underperformed the market over a long period of time. Investors who show keen interest in the markets can get access to portfolios managed by professional investors at a minimal price. It also allows access to portfolios of veteran PMS fund managers at a fraction of the minimum cost set by SEBI to enter into a PMS — the minimum investment amount for investing in a PMS is Rupees 50 lakhs. For a person starting out, that amount might be too much. If you feel like you have gained a fairly decent idea of the equity markets and want to try your hand with the guidance of professional fund managers, then this is the right tool for you.

Think of smallcase investing as paying a professional to sit behind you while you ride your cycle. The certainty and speed of your outcome/returns will be highly correlated to strategy and quality of the fund manager you choose. Statistically, it is too soon to tell whether any smallcase can beat the markets over a long time period, but the space definitely looks very promising and exciting.

Do it Yourself (DIY)

DIY has been placed at the end of the spectrum since investing yourself without any knowledge of the Markets can be tantamount to learning to swim in the ocean. As fun and rewarding as DIY can be, it must be supplemented with an active effort towards trying to learn the tricks of the trade. One must spend time in getting to understand the basics of the financial markets before one ventures into DIY. There is no fixed way to learn. You can learn by picking up books or enrolling yourself in a CFA program or just learning from people who have been in the industry for a long time.

A classic dichotomy arises here. You will never gain experience if you do not start. And without experience, you are bound to make mistakes. This is a dilemma that every new investor faces. Knowledge, patience and perseverance are your good friends. If you want to learn more about the equity market, then doing it yourself can be a great way of learning how to manage funds as:

• It teaches you how to manage risk and how to allocate funds
• It tests your emotional ability in ways you react to the market changes
• It allows you to buy smallcap / microcap companies that MF’s / Small Cases can not buy due to liquidity constraints.
• As an individual investor, you can choose to concentrate your holdings or follow any strategy you like. Fund managers are running a business and are answerable to their investors which prevents them from excessive concentration. You are not answerable to anyone — just yourself.

Taking our cycle analogy forward. Let’s take two cases here.

Case 1 — Bull Market: DIY investing is like driving a cycle without any trainers on the highway. In the Bull market, roads seem empty and it feels like a joy to drive freely as all go ahead on the one-way corridor.

Case 2 — Bear market : DIY investing is like driving a cycle on the highway except this time, the roads are not empty. Suddenly the trucks emerge and you find yourself on an open two-way road. Only the best make it to the end.

We suggest that you spend some time brushing up your basics and then get into DIY. A great way to start can be to manage a virtual fund where the stakes are low. The ET Money app offers the feature for free. This will give you a hang of what it feels like to see your stocks go up and down. After some experience and knowledge building is done, we suggest you foray into the real game albeit with a small capital. Try to see how you feel about the sport of Equity investing and gauge whether your interests lie here. If you feel that this is the game for you, then try to raise the stakes slowly as your experience increases and keep tabs of the index to know how you are performing.

Conclusion

Like Debashish, if you feel overwhelmed by the load of equity information and products out there, we hope that you have a better idea now. There are some common principles that emerge in all products. You must not mistake past performance for guarantee of the future. You must not mistake the bull market for skill. At the end of the day, time in the market is much greater than timing the market as they say.

Debashish was intrigued by the stock market because his friends doubled their money in 6 months. While those returns are highly sporadic, all you need is a neat and simple 15% annualised return to double your money every 5 years. Such is the power of compounding — the eighth wonder of this world — as Einstein called it.

Appendix

Below is a sample portfolio allocation to different equity products for a new investor based on the risk appetite followed by a summary of the pros and cons of the different products discussed in this article.

Note: The below table is by no means the only way you can allocate funds. There can be multiple ways of deciding the allocation.

Sample Allocation based on Risk Profile

Summary of Pros and Cons of different strategies

Note: Some of the above pros and cons can be interchanged based on the user’s profile and personality. A con for some like a long-term time horizon can be a pro for another investor.