With 2016 being one of the most volatile years so far for the stock market, many investors may be wondering whether it makes sense to buy funds rather than shares. After all, funds can offer significant amounts of diversification, which helps to reduce company-specific risk. This could help an investor’s portfolio to offer a more stable and robust return moving forward.
However, diversification can still be easily achieved through buying slices of companies instead of buying a fund. Certainly, a fund that owns hundreds of stocks may not be easily replicated, but the reality is that most of the benefits of diversification come from the first attempts to diversify. In other words, the marginal benefit of diversifying falls as more stocks are purchased, therefore it may not be necessary for investors to buy hundreds of stocks in order to reduce company-specific risk to an acceptable level.
All your eggs in one basket?
In any case, many funds focus on one specific region or one sector. For example, they may be US or UK-focused, or specialise in resources companies or consumer stocks. Similarly, they may have an income or capital growth tilt, or be focused on large caps or small caps. Therefore, there’s still the potential for volatile performance, since any one of those categories can perform much worse than the wider index in the short run.
For instance, in 2016 the resources sector has been hugely disappointing, so funds focused on that space have generally lost value. Similarly, China-focused funds have been relatively disappointing performers, while the uncertain prospects for the world economy have caused the valuations of riskier growth stocks to come under a degree of pressure. Therefore, buying a small number of funds may not reduce a portfolio’s risk by as much as is often perceived.
Low-cost solution
In addition, the costs of share ownership are generally much lower than buying units in a fund. This is especially the case with actively managed funds where performance fees can be steep and even wipe out any alpha generated by the manager of the fund. And while shares can be expensive to trade, aggregated orders are a sensible option for smaller investors and mean that purchases can be undertaken for as little as £2 per trade.
Of course, funds are often viewed as being less time-consuming than shares. For investors who have no desire to conduct any kind of research into a company then they’re often viewed as the perfect solution. While this is true to an extent, the reality is that funds must also be analysed before purchase since the performance of different funds can vary greatly. And with information on shares being easily accessible now thanks to the internet, obtaining the information needed to understand which shares have the best long-term potential has never been more straightforward.
So, while buying units in a fund can be a good idea for specialisation in a specific region or sector (for example in Chinese stocks or in the oil and gas industry), shares seem to offer the more compelling investment case. That’s not to say that funds aren’t worth holding, but rather that it may be sensible to devote the majority of capital within a portfolio to shares rather than funds.
