Whenever, we talk of investments, the most common instruments which come to mind are Mutual Funds, Shares or Derivatives (Options and Futures). Despite all having the same underlying asset, ie Shares, all the three sub classes are unique in their characteristics. And therefore they demand different treatment. It is a great folly when we tend to apply tactics and strategies/methodology of one sub class to the other. This tendency effectively dilutes the benefits of each class.
Commonality
All the above-mentioned sub classes belong to the Equity Asset Class and therefore have some similarities. The underlying asset in all sub classes is Shares. SEBI regulates all three of them. We can trade close ended Mutual Funds, Shares and Derivatives on Exchanges like BSE & NSE.
Uniqueness
Shares
This is the common element in all three sub asset classes. As we all know, we can buy & sell shares of publicly listed companies on the Exchanges. We do this through Brokers who provide us the Trading Accounts and other associated services. One share is further not divisible. The exchanges provide us the prices which change every moment as trades keep happening. Investors can continue to hold shares once bought for as long as they wish. The hold them till such time, they sell them again. This duration could be in seconds, minutes, hours, days, weeks, months or years as per the investor’s assessment and discretion. During the holding period the investor may receive income in the form of Dividends , which is the Firm’s distributable profit. The timing of buy/sell decision, is more important than the duration of holding.
Mutual Funds (MF)
Mutual Fund Houses are Trusts which run various well-defined schemes as per regulations of SEBI. Experts and Professionals manage the scheme on behalf of the investor. Schemes charge a fee for their service which they indicate as Expense Ratio. When we give our money to the MF, they buy a basket of instruments (Equity shares in case of Equity Funds). And they hold them till they decide to sell. The Fund Manager takes decisions on what to buy/sell, and when to buy/sell. This is done within the parameters laid down by SEBI. All SEBI regulations aim to benefit the investor and secure their interests.
Further there is a very robust oversight mechanism to ensure that the Schemes do not violate the rules. Investors are allotted MF Units, which are indivisible. The cost of MFs units is defined as NAV (Net Asset Value). MF Schemes calculate the NAV every day. NAV is based on the closing price of shares held, liquid cash available, income accrued and liabilities on the day. The formula is such that every investor benefits/looses in the same proportion as the change in value of underlying assets.
While investors can exit at any time, there is an exit load if they redeem within a year. An investor can opt for either the Dividend option if he wants to receive gains as regular income, or growth option if he wants to receive gains as Capital gains. MFs permit investors to take benefits associated with economies of scale with small amounts of investment. The duration of holding is more important than the timing of buy/sell. Investors can automate their decisions through Systematic Investment Plans (SIPs)
Derivatives
Futures and Options are derivatives of Shares. Derivatives might be confusing to those who are not yet exposed to these instruments. Suffice to know, that the primary purpose of these instruments is to mitigate downside risk in the value of held assets. This is done by taking position in Futures, or Options. It is however, also a fact that most of the trading in Derivatives today is speculative in nature. The peculiarity of these instruments is that these are contracts which expire at a fixed date and time. One can indulge in large quantity of underlying Share/Index at lower cost, thereby leveraging available funds. This accompanies a corresponding magnification in the likely return and losses.
Common Follies
(a) One common folly is to treat MFs like shares and indulging in frequent buying & selling. Almost all investors are prone to doing what is not advised/taught, ie they try to Time the Market. MFs need at least one to two business cycles to show results and therefore it is not prudent to exit before at least one year of holding. The advisable period is for five years, depending on the scheme performance. No MF is a perpetual performer, and therefore the tendency to chase the leaders should be avoided. More important is to pick potential leaders.
Within mutual funds there is a wide category of schemes which provide a well-diversified portfolio. You can read the details here (25 Types of Equity-Oriented Mutual Funds. Which One Suits You ?). Historically, almost all MF schemes tend to give positive and expected returns over a 5 to 10 yrs horizon, and can be treated as linear in nature.
(b) Second folly is to treat shares like MFs, and continue to hold losers for a long time. It is important to keep booking profits in performing shares, and also disposing non-performing stocks. Shares do not necessarily give linear growth like fixed deposits which increase with time. A non-performing stock can become penny stock in short time.
(c) Third Folly is to indulge in Futures & Options without developing a fair understanding of the complex matrix of various factors which affect risk and return of these instruments. One focusses on the possibility of magnified returns, loosing sight of simultaneous possibility of high losses.
(d) Fourth folly is to develop affiliation to one sub asset class, and discard others. This is more important for those who indulge in Derivative without holding any Shares. Further those who deal only in Shares and not in MFs. Those who are holding only MFs are fine and should expand to direct dealing in shares. Thereafter they can indulge in derivatives only to the extent that they are comfortable. But they should do this without diluting their holding in MFs. One can hold all the three, ie Mutual Funds, Shares and Derivatives in the Portfolio. Suggested proportions of Equity capital distribution are (a) MFs-100%, or (b) MF-75% and Shares 25%, or (c) MFs-60%, Shares -30% and Derivatives-10%.
Conclusion
If Share is the horse then Mutual Funds are the stable, and Derivatives are like Derby. The method of riding the horse, or managing a stable, or betting on a Derby, are all different. It is therefore important that our treatment of all three, and the methodology of managing them, also reflects this difference. Our objective should be to benefit from all, and suffer from none.