Most people don’t have…
… expertise to research stocks
… time to monitor the portfolio
… aptitude to handle market volatility
… inclination to work hard.
So, they simply choose the simplest of the routes to invest in stocks — buy what the fund managers are buying — and hope to make tons of money like them.
Warning: Also known as ‘mirror investing‘, this copycat approach has serious drawbacks.
One: Fund managers buy and sell stocks with the primary objective of beating the markets and making maximum profits. They have to create ‘alpha’ and be counted among the ‘best investors’. Otherwise, no one will invest in the fund(s) that they are managing.
People, on the other hand, invest with the aim of meeting their particular financial goals (e.g. children’s education, house, marriage, retirement, vacations, mobiles, etc.). And, as long as these objectives are comfortably met, it is immaterial whether they have bought the best stocks or not. It is immaterial whether they have outperformed the market / other investors or not.
Since the objectives differ, naturally the selection of stocks cannot be the same.
Two: How many stocks does a typical mutual fund scheme invest in? Normally around 30-50 stocks (or more depending on the corpus size).
But what about aam investors? Since most of them have limited capital, they will find it almost impossible to buy all the 30-50 stocks. So they will have to pick and choose and probably copy only a part of the fund manager’s portfolio.
This limits the diversification that they can achieve and hence increase the concentration risk.
Three: Even if someone can manage to buy all the 30-50 stocks in a fund manager’s portfolio, the transaction costs will balloon. Their brokerage and other charges will be far more than that of a fund.
This will affect the returns and probably defeat the very purpose of buying all the stocks in a particular fund, rather than investing in the fund itself.
Four: Besides, just knowing the stocks which a fund manager has bought is not sufficient. We don’t know at what price the fund manager bought the stocks. We don’t know how long s/he intends to hold them. We don’t know his/her exit strategy.
Therefore, with only limited information, duplicating or copying a fund manager is like playing a lottery, not an ‘informed’ process of investing.
Five: Mutual funds don’t have to pay tax when they sell shares in the portfolio.
But people are liable to pay short-term or long-term capital gains tax, as the case may be, on every sale transaction. This would easily eat away the 2-3% annual fund management expenses, which they are trying to save by directly investing in stocks.
Six: Fund managers buy and sell stocks practically on a daily basis.
People become aware of these transactions much later, when the portfolio is published in the public domain. So, by the time they come to know what particular stocks the fund manager has bought (or sold), it may be too late.
This time lag can have serious consequences.
Seven: A typical fund will have to honour many redemption requests… everyday. Therefore, it has to keep aside a part of the corpus in cash. On the contrary, fund managers can conveniently handle large and sudden redemption pressures due to the large size of their portfolio.
Individual investors can invest 100% of their corpus. But, with their small-sized portfolio, they will find it extremely difficult to withdraw large sums at short notice.
This trade-of between returns and liquidity could also affect the choice of stocks. Shares that are good for the fund to own may not necessarily be good for an individual too.
Eight: Some stocks are risky e.g. the mid-cap / small-cap stocks or the contrarian bets. Large diversified funds have the risk appetite to hold such stocks.
Whereas, an investors with a limited portfolio, would be exposed to too much risk if they try to own such stocks.
Concluding: It is foolhardy to try and copy the fund managers. Investors would be far better off by simply investing in the schemes managed by them.