Which is Better – DIY or Mutual Funds?

The last one year has been fantastic for literally everyone other than those who held too much Cash or were straight away bearish. Nifty went up nearly 60% in the last one year. 65% of stocks traded on the NSE did even better than that. Trend following systems had a splendid time as did Value or Growth factors. Only the quality factor trailed a bit but in the long term, they have performed much better than most other factors.

A good bull market brings a lot of hubris to those who were lucky to be part of the wave. From thinking about quitting one’s job and taking up trading / investing as full time to deciding to invest everything based on one’s own analysis, it’s easy to assume that we know better and it’s worth changing. 

Bull markets like the one we saw in the last one year are kind of pretty rare. While we have been in a bull market from 2013 onwards, the first leg of the bull market is the one that really shores up the returns. The next couple of years while good are generally in no way comparable to the first.

In the last few days there has been a lot of hoopla around Index funds raising their expense ratios. This is because the expense ratio went up from 0.10% to 0.20%. I am if you are a regular reader of this blog and belong to the old school, the school that cost me 2.5% for purchasing a piddly stock, 0.20% to me is still way cheap given how impossibly tough it is for Individuals to actually replicate the same directly in the markets. 

The other day I was talking to a prospective client and he mentioned that his weakness was his own behavior. While he felt that this was a negative and it indeed is, I felt that the positive was his ability to understand his own point of weakness. Very few actually are able to analyse their own Strength and Weakness let alone work on how to eliminate the weakness. 

If you were to invest say a sum of 50 Lakhs into a PMS, over time you should expect to pay the fund manager approximately 2 to 3% of fee or 1 Lakh to 1.5 Lakhs per year. A mutual fund bought through a distributor would cost you similarly. A DIY on the other hand can be multiple times cheaper than this. Even after the fee hike, an Index fund will still cost you just around 10K per year which is more or less in line with most advisory fees. 

If the returns are the same, it’s easy to wonder as to why people are willing to pay such a high fee when the same products are available at a fraction of the cost. Unlike a MF where your return is the same as others for the period you have invested or Unlike a PMS where your return will be in the same ball-park of returns generated by the fund manager across all clients, with DIY, there is no knowledge of whether even the advisor was able to reap the returns he showcases as having achieved.

I keep seeing stock advisors berating mutual fund returns vs their own returns and recommend that investors are better off with them vs Mutual Funds. The markets being as it is has helped sell that idea a lot. To me though, this is a very wrong advice for the single reason that the greatest reason for our inability to even garner a fund’s return is our behavioral gap and if that is the case with funds where our decision making is actually limited, how much of the gap shall one see in case of stock based portfolio’s is anyone’s guess.

Another frequent question I am asked by new clients is whether they should buy the stocks that are part of the portfolio but have moved up a lot since their induction into the portfolio. The question in itself is not wrong but betrays how we think when we are buying stocks. No one is immune to it, even I after seemingly having experienced and knowing my weakness still wonder many a time as to whether the stock which has now qualified to be part of the portfolio deserves to be part of the portfolio given how much it has already run up in recent times.

A mutual fund or a PMS doesn’t give much thought to such considerations even though the risk from the stock is the same at both places. In other words, for the fee you have paid, you are not just getting a list of stocks to execute but the ability to execute without your own behavior impeding future returns.

So, what is the key difference vs DIY, especially with respect to stocks?

In 2009, DSP Blackrock Smallcap Fund had fallen 75% from its peak. In other words, if the peak equity value was Rs.100, it was now just 25. If one’s portfolio had performed that way, it’s unlikely the investor would have ever recovered his money let alone come roaring back and this particular fund did. By the end of 2017 this fund was the best performing equity fund.

In March 2019, exactly 10 years from the bottom, the NAV was 54 (which itself was 28% lower from the peak it touched in early 2018 of 73) and the 10 year CAGR return came to 28.30%. Not bad for a fund I assume most advisors and investors would have written off in 2008/09.

While one of the key differences in returns between DIY or even a PMS and a Mutual Fund is the way profits are taxed, the biggest advantage of a Mutual Fund is that you are essentially passing off not just selection of securities but the execution to someone else.

Last March as the fear of Corona spread and the market panicked, my portfolio got crushed. Between the starting of the month to the deepest point of drawdown, I lost 32% of the value of my portfolio. From being in profit, I was suddenly starting at a loss of 22% of the total invested capital. Since I had started investing from May 2017, this meant that I was negative after continuously investing for nearly 3 years.

In hindsight what saved me I think was the reading of books which suggested that this too shall pass. If I was younger, I wonder if I could have kept my calm and carried out what the system suggested for when fear strikes the mind, the best systems are overridden. 

One of the simplest ways to trade the market is using a simple trend following system. Buy Nifty when it’s above its 200 day EMA and sell when its below generates returns that are slightly lower than Nifty (no leverage) but with nearly half the maximum drawdown. Yet, very few can really practice this simple strategy for trend following asks you to buy after the index has gone up quite a bit from the lows while asking one to sell after it has fallen quite a bit from the highs. Both are tough from the behavioral point of view. 

It’s for this reason that most investors try to time the market by trying to buy when it’s low and sell when it’s high. Given that other than in hindsight we never know when the final highs and lows are made, this generally results in massive underperformance. 

Being a Technical Analyst for a very long time, I have always ridiculed the phrase “you cannot time the market”. While I agreed that you cannot time the market to perfection, I have always felt that timing the market does add value. But if you were to think about it from the behavior point of view, trying to time the market for most investors fall flat because their behavior obstructs them from doing the right things.

If you haven’t’ experienced a real bear market (March 2020 wasn’t one of them), I strongly believe that the majority of your exposure to markets should be via Mutual Funds (Large Cap Index Funds preferably) with a small minority (say max at 30%) devoted to do it yourself models if you are interested.  No one gets a free ride in markets and we all pay the tuition fees to the market. Having a smaller segment of your portfolio in DIY ensures that the tuition fee is bearable and doesn’t create havoc with your long term goals.