UNDERSTANDING INVESTING IN MUTUAL FUNDS
Mutual Funds: What does it mean?
A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s investments and attempt to produce capital gains and/or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a lot of securities, and performance is usually tracked as the change in the total market cap of the fund, derived by aggregating performance of the underlying investments.
Mutual fund units, or shares, can typically be purchased or redeemed as needed at the fund’s current net asset value (NAV) per share, which is sometimes expressed as NAVPS. A fund’s NAV is derived by dividing the total value of the securities in the portfolio with consideration of all expenses related to fund management by the total amount of units outstanding.
Kinds of Mutual Funds
Mutual funds are divided into several categories, representing the kinds of securities the mutual fund manager invests in.
Open End Mutual Fund: is a type of mutual fund that does not have any restriction on the amount of shares it will issue. An investor will generally purchase shares in the fund directly from the fund itself rather than from the existing shareholders. Open End mutual funds are not traded in the organized markets i.e. stock exchanges. The expiration of these funds are perpetual in nature.
Closed End Mutual Fund: raises a fixed amount of capital through an Initial Public Offering (IPO). The fund is then structured, listed and traded like a stock on a stock exchange. The expiration of these funds are predetermined with fixed timeline.
Fixed Income Mutual Fund: focuses on investments that pay a fixed rate of return, such as government bonds, corporate bonds or other debt instruments. The idea is the fund portfolio generates a lot of interest income, which can then be passed on to shareholders.
Index Funds: The investment strategy is based on the belief that it is very hard, and often expensive, to try to consistently beat the market. So the index fund manager simply buys stocks that correspond with a major market index such as the S&P 500 or the Dow Jones Industrial Average. This strategy requires less research from analysts and advisors, so there are fewer expenses to eat up returns before they are passed on to shareholders. These funds are often designed with cost-sensitive investors in mind. If an investor seeks to gain diversified exposure to the Canadian equity market, he can invest in the S&P/TSX Composite Index, which is a mutual fund that covers 95% of the Canadian equity market. The index is designed to provide investors with a broad benchmark index that has the liquidity characteristics of a narrower index. The S&P/TSX Composite Index is comprised largely of the financials, energy and materials sectors of the Canadian stock market. Performance of the fund is tracked as the percentage change to its overall adjusted market cap.
Balanced Funds: invest in both stocks and bonds with the aim of reducing risk of exposure to one asset class or another. Another name for this type is “Asset Allocation Fund.” An investor may expect to find the allocation of these funds among asset classes relatively unchanging, though it will differ among funds. However their goal is asset appreciation with lower risk, these funds carry the same risk and are as subject to fluctuation as other classifications of funds.
Other common types of mutual funds: are money market funds, sector funds, equity funds, alternative funds, smart-beta funds, target-date funds and even funds-of-funds, or mutual funds that buy shares of other mutual funds.
Why Mutual Funds?
Diversification: Diversification, or the mixing of investments and assets within a portfolio to reduce risk, is one of the advantages to investing in mutual funds. Buying individual company stocks in retail and offsetting them with industrial sector stocks, for example, offers some diversification. But a truly diversified portfolio has securities with different capitalizations and industries, and bonds with varying maturities and issuers. Buying a mutual fund can achieve diversification cheaper and faster than through buying individual securities.
Economies of Scale: Mutual funds also provide economies of scale. Buying one MF unit spares the investor of the numerous commission charges needed to create a diversified portfolio. Buying only one security at a time leads to large transaction fees, which will eat up a good chunk of the investment.
Easy Access: Trading on the major stock exchanges, mutual funds can be bought and sold with relative ease, making them highly liquid investments. And, when it comes to certain types of assets, like foreign equities or exotic commodities, mutual funds are often the most feasible way – in fact, sometimes the only way – for individual investors to participate.
Professional Management: Most private, non-institutional money managers deal only with high net worth individuals – people with six figures (at least) to invest. But mutual funds are run by managers, who spend their days researching securities and devising investment strategies. So these funds provide a low-cost way for individual investors to experience (and hopefully benefit from) professional money management.
Individually-Oriented: All these factors make mutual funds an attractive option for younger, novice and other individual investors who don’t want to actively manage their money. They offer high liquidity; they are relatively easy to understand; good diversification even if you do not have a lot of money to spread around; and the potential for good growth. In fact, many Americans already have invested in mutual funds through their 401(k) or 403(b) plans. In fact, the overwhelming majority of money in employer-sponsored retirement plans goes into mutual funds.
Style: Investors have the freedom to research and select from managers with a variety of styles. Mutual fund managers focuses on value investing, growth investing, developed markets, emerging markets, income or macroeconomic investing, among many other styles. One manager may also oversee funds that employ several different styles.
7 commandments every Mutual Fund Investors should know
Know your Expense Ratio
While investing in a mutual fund is definitely not a humongous task, it is important to take note of critical aspects like the expense ratio of the fund before you choose to park your hard earned money with fund houses. Since expense ratio is a charge deducted from assets, it is implied that higher the expense ratio, higher the charge on your investments. Also longer the investment period, higher is the impact of expense ratio on investor’s returns.
The below table shows how the value of Tk. 1 lac with 12% annual returns varies with different expense ratios. Fund A with lowest expense ratio has become Tk. 7,50,071 in a span of 20 years while Fund C with highest expense ratio has become Tk.5,81,370. The difference between the highest and lowest expense ratio is Tk.1,68,701.
In the above example, the difference between the expense ratios of the three funds is probably because of the higher commissions, management fees, marketing budget etc paid by the Fund B and Fund C. It is like losing Tk. 1.68 lakhs over 20 years, i.e. about Tk 8,000 annually. Expense ratio of direct plan funds are lower compared to regular plans since the former is bought directly from the AMC. Difference in return gets magnified with a higher investment period so it would be prudent to pay attention to what their fund’s expense ratio is, especially as a long term investor.
Maintain Investment Discipline
Markets reach all-time highs and investors start to receive calls to either invest or even worse exit their investments and ‘cash in’. In an effort to make the most of the market rally, the mistake they generally make is to exit from their investments – investments which could have the potential to give them much more than they might have got at the time of exit. When investing, you need to understand, that it is very important to continue being disciplined and that investments should always be linked to your financial goals. This stands true, especially in the case of equities. Equities are more of a long term investment option, since equities as an asset class has the potential to give good returns over a long period of time (with higher risk). Therefore, it is advised that you hold on to four investments even if the markets are not moving in a favorable direction. Moreover there is one way you can negate the effects of market cycles and also bring financial discipline in your investments – SIPs. Systematic Investment Plans or SIPs are said to be an ideal way for investors to create wealth in the long term.
Adequate Research before Investing
Sure, distributors or advisors can be of a help when choosing a mutual fund, but you should ideally do some research on your own as well. With the advent of the internet it has become a lot easier to simply key in the name of the fund, check the pedigree of the fund, the performance etc before investing. One needs to understand, that investing, especially in equities comes with associated risk. Therefore basic research on which kind of asset class should you park your money in, whether the fund you are looking for has a good track record in the past, etc will help you be that much more confident while making the investment.
Never Compromise Financial Goals for Some Quick Gains
The tenure of your goal should determine which asset class you should invest your hard earned money. If the financial goal is for the long term then you should ideally invest in equity provided you have a high risk appetite, as equities have potential to give higher returns with higher risk over a long term period. Investments should not be subject to any market up-swing or external influence. If your goal is shorter say one year then Fixed Income instruments may make more sense.
Investments made for retirement should not be cashed in only because the markets are on a high. Our advice to you, our investor has been to withdraw your investments based on need and not on greed.
Go with Funds Provide Cash Dividend (Avoid Re-Investment Units)
Always put your attention on the mutual funds those pay cash dividends at regular intervals i.e. usually annually. It is good for an investor if he finds any fund that pay cash dividend which grew in line with the NAV. Cash dividends can always make you happy and can help you to minimize your cost price by adjusting the dividend with your purchase price.
Investment Decisions Based on Returns and the Risks Associated
Most people park their hard earned money across asset classes without as much as a second glance at their personal risk taking capacity. And that’s pretty tragic considering that their risk profile would be starkly different from that of their next door neighbor, on whose recommendation investors tend to buy stocks, when we hear that he has made gains of x%!
Always consider the risk involved while investing in any financial product. You should ideally look for sensible, risk-adjusted returns over the long term through a fund house that follows a disciplined research and investment process. Look at the track record of the fund house, and the process they have in place to ascertain the risk investors are taking, not how big the fund house is. Remember, the returns that a mutual fund could make, is not a function of size. The Risk-Return analysis is yet an important aspect of mutual fund investing.
Never assume that funds with higher NAV perform better
Sometimes you tend to link NAV to absolute returns of a fund. Therefore, higher NAV is taken to be synonymous with higher return. This is not necessarily true. NAV sure is a tool to measure performance but NAV is not a performance indicator in itself. It is change in NAV of two dates that reflects performance of the fund in the period between those dates. However it is true that with age the NAV of a fund increases; that’s why older funds tend to have higher NAVs. Moreover, the unit price which is below to NAV per unit offers you to buy at discount and that can be a useful metric to measure funds’ performance.
To conclude these 7 commandments are meant to help you take care of your investments and make the most of your hard earned money.