Guide to Investing in Mutual Funds

Mutual funds are popular amongst investors who may not have the wherewithal or the inclination to invest in individual stocks and bonds, or who prefer to rely on the expertise of professional investment managers. In this post we will cover the basics of how mutual funds work as well as the factors to consider when selecting mutual funds for your portfolio.

A mutual fund is an investment vehicle that involves pooling funds from investors and investing those funds in accordance with a specified investment strategy. This investment vehicle is structured as a separate legal entity, usually in the form of a trust, that is effectively owned by investors and managed by a trustee. Various financial institutions such as banks, insurance companies and asset management firms set up mutual funds to attract money from investors who are issued units as evidence of their ownership interest. As a special purpose entity, the mutual fund has no employees, but enters into legal agreements with service providers such as an investment manager, a custodian, an administrative manager and a distribution agent. Most of these services are usually provided by the institution that established the mutual fund.

The money raised by a mutual fund is used to acquire assets such as stocks, bonds and money market instruments, depending on the investment strategy. Investors indirectly own these assets and are entitled to any returns they generate. After the payment of fees for the various services and other fund expenses, the remaining cash flow is available for distribution to investors or for reinvestment. Also, in the event of a liquidation of the fund, net proceeds from the sale of the assets would be distributed to unitholders. The value of a unit in the mutual fund is therefore represented by the total value of the mutual fund assets, minus any liabilities, divided by the total number of units. This is referred to as the net asset value or NAV.

Based on market convention, mutual funds are categorized according to the investment strategy they pursue, which is usually reflected in the name of the fund. The most common categories of mutual funds available in Trinidad & Tobago are:

  • Money market fund (MMF). These invest in high quality, short-term fixed income securities such as treasury bills, commercial paper and bankers acceptances. MMFs generate low returns but have a very low risk of loss of capital invested and are the closest investments to a regular bank account. The Trinidad & Tobago Securities and Exchange Commission’s guidelines on collective investment schemes stipulate that a mutual fund shall not have “money market” in its name unless 90% of its assets consist of cash, cash equivalents and securities maturing in less than one year.
  • Income fund. These funds invest primarily in fixed income securities such as bills, notes and bonds, as well as dividend paying stocks, with the objective of having a regular distribution of income. Income funds are usually low to moderate risk investments with the level of risk depending on the credit rating and tenor of the securities in the portfolio. Lower credit quality and longer tenor bonds increase the risk from losses due to default or changes in market value. Some income funds in Trinidad & Tobago have a fixed NAV where purchases and sales are made at this NAV, with the financial institution sponsoring the fund essentially guaranteeing the fixed NAV.
  • Growth and income fund. These are also referred to as balanced funds and have dual objectives of generating regular income combined with achieving capital appreciation. To achieve these goals, the fund holds fixed income securities to provide income and stocks to provide some income but mainly to generate growth. This type of fund is considered higher risk than income funds as it has a greater proportion of stocks.
  • Equity or growth fund. As the name indicates, these funds invest almost entirely in stocks with most of the return being generated via capital gains. There is a diverse range of equity funds available with varying objectives and risk profiles depending on the type of stocks held in the portfolio.

The following are some of the reasons why investors choose to invest in mutual funds:

  • Professional management. Funds are managed by investment professionals with the knowledge, experience and resources to navigate the market and therefore generate better returns than non-professionals.
  • Diversification. Through mutual funds, investors are able to gain exposure to a diversified pool of investments that would not be possible if they had to acquire individual securities, resulting in reduced investment risk as that risk is spread over many positions.
  • Small investment amount. The minimums for mutual funds are generally low which means they can be accessed by investors with small sums to invest. Investing directly in stocks and bonds usually requires larger minimums that some investors may not be able to meet.
  • Dividend reinvestment. Mutual funds facilitate reinvestment of distributions at no cost which may not be possible with direct investing.

Despite the advantages of mutual funds, there are still issues to navigate with this type of investment. If you decide to allocate a portion of your portfolio to mutual funds, you should consider the following when selecting specific funds:

  • Risk tolerance. Mutual funds have different levels of risk so you need to ensure that the risk profile of the fund you are considering is aligned with your own risk tolerance. Money market and income funds are appropriate for the conservative investor, a moderate investor would consider income funds, balanced funds and a small exposure to growth funds, while investors with high risk tolerance can have a greater proportion of growth funds in their portfolio.
  • Historical performance. The returns generated by a fund depend on the investment strategy pursued and how well the investment manager has executed that strategy. It would therefore be useful to compare a fund’s historical performance to appropriate benchmarks for that strategy and to similar funds offered by other institutions to identify the best performing funds for each strategy.
  • Fees and other costs. There are two sets of costs to consider when investing in mutual funds. The first is fees and expenses charged to the fund for the various services provided, commonly referred to as the expense ratio. Local mutual funds do not publish their actual expense ratio so it is not possible to compare this cost across funds. Given fund returns are published net of fees, a comparison of the historical performance of various funds would incorporate any differences in fees. The second cost, commonly referred to as loads, represents commissions the investor pays upon the purchase (front-end load) or sale (back-end load) of a mutual fund. Not all mutual funds have loads so it is necessary to find out if the fund you are investing in has loads, and how such loads are calculated and charged.
  • Fixed or flexible NAV. Money market and income funds offered in Trinidad & Tobago have either a fixed NAV or a flexible NAV. With fixed NAV funds, purchases and sales are conducted at a fixed price so the investor’s return is the distributions made by the fund. The institution offering a fixed NAV fund is effectively guaranteeing the NAV with a commitment to making up any shortfall should the actual NAV fall below the fixed price. With flexible NAV funds, the NAV is calculated daily using the market value of the assets and fluctuates as market prices change. With such funds the capital value invested can go up or go down as the NAV changes.

Persons who invest in foreign mutual funds have some additional factors to consider such as whether to go with funds that follow an active investment strategy or those that are passively managed to track an index, and whether to use regular mutual funds or exchange traded funds (ETF’s). Both factors require in-depth analysis and will be the subject of separate posts in the future.

In conclusion, mutual funds can be a suitable investment option for individuals who would like to start investing small amounts and want to benefit from the professional management of such funds. It is also an option for those with large amounts to invest, although they also have the choice of a separately managed portfolio tailored to their specific requirements. Despite the relative simplicity of mutual funds, it is still necessary to perform proper due diligence and obtain appropriate financial advice before investing in such funds.

 

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