Equity Mutual Funds by definition manage a large size portfolio pooling resources from small investors. For reasons of managing large portfolio they need to invest in a very large pool of stocks and to manage liquidity they also need investments into very large cap stocks. For an investor who wants to create wealth out of his investible surplus, a mutual fund reduces his return substantially due to extreme over diversification as your asset allocation can easily be put only into 5 – 10 well researched companies than into too many stocks and, into high market cap behemoths with limited growth opportunities or limited PE (Price Earnings Ratio) expansion capabilities. If you manage your portfolio yourself with help of a competent investment adviser, or entirely by yourself if you know where to invest when and how much; you can generate much much higher returns without increasing any risk.
An example may be pertinent here: Suppose you put Rs. 500,000/- in a mutual fund whose total Asset Under Management (AUM) is Rs. 25,000 crores. So, your portfolio is a very very insignificant fraction of its total portfolio (0.0002%). Now for managing the large size of the portfolio it needs to buy too many stocks and front line stocks with high market cap and high liquidity like Infosys, Reliance, TCS, HDFC Bank, Wipro etc. Now these are all excellent companies but can’t really give returns which are meaningful for you. Also, the diversification which is beneficial at fund level is not beneficial at individual investor level. Instead, if you invest only in maximum 5 – 10 stocks which are well analyzed, well researched and also run by great management team in a growing market and presently much smaller than these large companies, your return can be phenomenally higher and very meaningful as it may come from two sources namely, growth of the company from a relatively smaller base and PE expansion due to the recognition of its performance by market.
Also, a Mutual Fund performance is internally measured by the AUM (Asset Under Management) and Return. Bigger their AUM, better are their fees as fees are calculated as a percentage of AUM and there is a ceiling. So, certainly, they would like to make their AUM bigger. Now, larger the fund size tougher are the challenges for generating higher returns as, due to their sheer weight, they become less nimble and more restricted. If you check the portfolio of any mutual fund in India, you will possibly see that 50% or more stocks are similar in all of their portfolios.
It doesn’t mean Mutual Fund industry is bad or run by incompetent people. Their business model restricts them for generating return which are meaningful for you. However, a mutual fund may be an ideal route for a person investing very small sums of money or those not interested in directly handling the investments and / or are happy with their Mutual Fund returns.
Ultimately you have to decide what suits you and your long term financial goals best.