Today we will explore the advantages of mutual funds as investments.
I believe mutual and exchange traded funds (ETFs) should be the cornerstone of most investors’ portfolios. This is especially true for investors who have have yet to accumulate significant wealth. However, even for those with substantial portfolios, funds are often the wisest investment path.
Why do I think this? What are the advantages of investing in mutual funds?
Investment Options
As we saw in our Mutual Fund Introduction, there are a vast number of funds available for purchase in a multitude of investment styles and asset classes.
Previously, we reviewed various Mutual Fund Categories. You can invest in specific asset classes, such as fixed income or equities. You can also invest in funds that follow specific investment strategies or analytics. If you want funds following value or growth strategies, no problem. You want dividend yield, there are many funds to invest in. Small-cap, biotech funds from Israel? You can find those too. Pretty much everything can be found in a specific fund.
This allows you to easily create any combination of assets within your portfolio. Also, to quickly adjust these combinations as your personal circumstances change.
You may even find funds that allow access to investments that you could not feasibly acquire on your own. Real estate, venture capital, and fine art are examples.
When we discuss asset allocations and portfolio returns, you will see that having ready access to a wide variety of assets is vital to investment success.
Diversification
Diversification is an extremely important feature of funds, especially for smaller investors.
Diversification allows one to reduce overall portfolio risk while maintaining the same level of expected returns. It also allows one to invest in riskier assets that have higher expected returns without increasing the overall portfolio risk.
A very useful tool to incorporate in one’s investment strategy. Probably the most important aspect of successful investing.
For more information on diversification, please refer to three earlier posts: An Introduction to Diversification; Diversification and Asset Correlations; Asset Correlations in Action; A Little More on Diversification.
Due to the number of investments held within a typical mutual fund, there is normally strong diversification already built in. Not always, as we shall discuss later, but usually.
Diversification within a fund will relate to the category of the fund. The diversification may be between: companies in specific sectors (e.g., oil and gas exploration equity funds); entire sectors and industries (e.g., consumer product equity funds); geographical regions (e.g., country specific, international, or global funds); maturity dates (e.g., long term bond funds); asset classes (e.g., balanced or asset allocation funds).
Smaller investors may not be able to diversify on their own through individual assets. This may be due to the lack of overall wealth, an inability to access investments across all asset classes, or the prohibitive cost in trying to diversify with limited funds.
As one’s wealth grows over time, an individual may be able to achieve adequate portfolio diversification on his own. But for any investor, even larger ones, mutual funds can provide excellent diversification on a cost-effective basis.
For example, the RBC O’Shaughnessy All-Canadian Equity Fund provides exposure to a variety of Canadian public companies. As at February 20, 2018, it holds 104 companies in its portfolio. How many investors have the wealth to invest in 104 different companies? Not to mention the time to analyze and track a portfolio of that size.
Cost Effectiveness
Diversification is crucial in investing. But it can be a costly endeavour.
To create a well diversified portfolio requires a significant number of different investments. In diversifying away the nonsystematic risk in equities alone may necessitate holding at least 30 to 40 different stocks. Then factor in fixed income, money market, and other asset classes (e.g., real estate, commodities) and one’s portfolio can become quite large.
This is especially problematic for investors in two cost-related ways.
First, when trying to diversify within and between asset classes, the average small investor tends to spread themselves thin when acquiring investments.
Second, buying marketable securities (stocks, bonds, etc.) involves paying commissions on each trade. The less securities purchased, or the greater the number of trades made, the higher the relative cost of the acquisition.
For example, to invest $6,000 in 30 different stocks, you are only able to invest $200 in each company. That may not allow you to purchase very many shares of any company. In some cases, $200 might not even allow you to acquire one share in some popular companies. Amazon, Google, Tesla (and many others) would be excluded from your investment options as all currently trade above $200 per share.
And even with low online brokerage rates of $10 per trade, you will spend $300 on commissions to buy 30 different companies (as opposed to only $10 had you bought just one stock). You will need to generate a portfolio return of 5% simply to recover the commissions paid. Not an easy endeavour.
By investing through mutual funds, you pool your money with many other investors. This provides an economy of scale to reduce the individual impact of commissions and allows for the purchase of assets of any value. Even Berkshire Hathaway A shares at a February 20, 2018 price of $306,000 per share.
Economies of scale also allow for better pricing on fixed income instruments. As greater amounts of money market instruments are purchased, the offered interest rate is typically higher than for smaller investments.
A third “cost” is the value of your time. Unless you love to spend your spare time analyzing investments (granted, who does not love that), then there is the cost of your time. Even investing in 30 stocks requires a lot of effort to identify potential investments and monitor your holdings. Funds simplify the process and time required.
Ease of Investing
One thing that brokers and mutual funds are great at is making it very easy to invest.
You can invest in funds either through the specific fund itself or via your brokerage account.
Note that some funds may not be available through your broker. Different brokers may offer different funds. Some offer a better selection than others. When choosing a broker, find one that offers a wide selection of funds for purchase.
There are many funds that do not have sales fees (front or back loads) which saves money. Often, brokers waive commissions for the purchase of certain funds that they sell. Or there may be no commissions when shifting money from one fund to another in the same fund family.
Again, when choosing funds or an online broker, consider the transaction costs associated with the fund purchase. Given the number of funds available, you should be able to fulfill your investment objectives entirely with no-load funds.
There are very few reasons why you should pay a sales fee or commission on a mutual fund. Avoid.
Many funds allow relatively small initial investments and even smaller subsequent purchases.
Some funds allow for automatic investments via monthly/quarterly/etc. direct debits from your bank account. These Direct Purchase Plans (DPPs) allow investors to invest without making an effort. It is also a superb way to engage in dollar cost averaging. A concept you should utilize and one we will cover later on.
Some funds offer Dividend Reinvestment Plans (DRIPs). Any distributions made from the fund are automatically reinvested into additional shares of the fund. Except for having to pay tax on distributions you do not physically receive, this is an excellent way to invest and accumulate wealth over time.
Liquidity
Liquidity, or ease of divesting, is another advantage of mutual funds.
Asset liquidity is important when assessing investments. To refresh, please review Liquidity Risk for Investors.
With some exceptions, most open-ended mutual funds are valued daily. These funds normally redeem (i.e., buyback) your shares (or units) each day based on the fund’s closing net asset value. Because the fund itself redeems the shares, open-ended funds are usually extremely liquid.
And by posting net asset values daily, investors have high certainty as to the proceeds they will receive on disposition.
Professional Management
Some believe this to be an advantage. Others actually believe it a negative.
In theory, having a mutual fund professionally managed should be a positive. The investments made are well researched. The portfolio is monitored to ensure proper construction for the style (e.g., a value equity fund has the best possible value stocks). And when it is appropriate to sell securities, they are sold in a timely manner.
In short, you are letting an investment professional make the investing decisions for you.
Assuming you are not a professional yourself, that should mean better investment decisions will be made than if you were left to your own devices. Also, by delegating asset management to a professional, you do not need to spend your precious time, researching and monitoring multiple investments.
In practice, this advantage does not always arise. In delegating the investment decisions to others, you must pay for that privilege in higher management fees. That might be okay if the annual performance of actively managed funds exceeded passive (no professional decision making) funds. But that is not always the case. Nor even usually.
We will look at the active versus passive debate in an upcoming post as it is an important issue.
While these advantages make mutual funds appear the ideal investment, there are some potential drawbacks or issues that must be considered when investing in mutual funds.
We will look at these next time.
