by WWM | Apr 4, 2018 | Mutual Funds
Previously, we reviewed mutual fund transaction and operating costs. Both have substantial impact on investor wealth accumulation. Another more obvious component of asset growth is mutual fund performance.
As we have covered investment return considerations a while back, this will be brief. Though a reread of the linked posts may be worthwhile.
Total Returns not Change in Net Asset Value
Always use total return when calculating or assessing fund performance.
Total return reflects the period change in the net asset value of the fund plus any income or capital distributions made to shareholders during the period.
It is important not to forget distributions or your results may seem poor.
Annualized not Cumulative Returns
When reviewing returns for periods greater than one year, the performance figures should be on an annualized, not cumulative, basis.
Annualized returns allow for better comparisons between periods.
Net not Gross Returns
Know what is included in the performance data you analyze.
When assessing fund performance, make sure that you review net returns and not gross.
Net returns are those that factor in fund total expenses when determining performance. As every dollar of expense negatively impacts your own return, you want to ensure that all the costs are factored in to the return calculation.
There is a trend to ensure that net returns are reported, but there are still some differences between regulatory jurisdictions in reporting requirements.
My Fund’s 5 Year Annualized Return was 11%
A fund’s performance is important when assessing potential investments and monitoring existing ones.
But knowing a fund’s return in isolation does not provide much information content.
If my fund returned 11% annually over 5 years, is that good?
Maybe. Maybe not.
To determine the answer we always need to put returns into proper context.
We shall consider relative performance in our next post.
by WWM | Mar 28, 2018 | Mutual Funds
Besides potential sales charges and brokers’ commissions, you incur ongoing fees for the costs associated with operating a mutual fund. These costs can differ significantly between funds and should be reviewed carefully before investing.
Assessing a mutual fund’s cost structure is key to investing success.
Minimizing Fund Expenses is Vital to Investment Success
Capital spent on items other than the actual investment is money that does not earn a return and compound on your behalf. As a fund’s expenses fall into this non-income generating category, they are extremely important to consider when investing in mutual funds.
For example, two global equity mutual funds each had a gross return of 10% last year. Fatcat Global Equity Fund had operating expenses of 5% Assets Under Management (AUM). Lean Global Equity Fund had operating expenses of 2%.
On a net basis, instead of identical returns, Lean had superior performance. If the same returns and expenses continue in the future, over time there will be a significant difference in shareholder wealth.
Perhaps you invested $10,000 in each fund. In rough calculations (ignoring taxes, distributions, assuming annual reinvestments, same annual returns and expenses, etc.), at the end of 5 years your Fatcat investment would be worth roughly $12,750 and Lean worth $14,700. At the end of 10 years, Fatcat would be worth $16,300 and Lean $21,600. After 20 years, Fatcat would be worth $26,500 and Lean $46,600.
Over time, that extra annual 3% in Fatcat expenses will have a significant impact on your compound returns.
Management Expense Ratio
The Management Expense Ratio (MER) reflects the annual cost of operating a mutual fund. Note that some areas of the world call this the Total Expense Ratio to reflect the inclusion of all costs. Then they consider the management fees separately. Just ensure you understand what is included in any fund ratio calculation.
The MER is made up of three fee or expense categories: management; administrative; marketing.
It does not include costs associated with buying and selling fund investments (e.g., commissions, loads, brokers’ fees).
Management Fees
A large portion of the MER is the fees paid to the fund managers or investment advisors.
These are the people that research possible fund investments, determine assets to include in the portfolio, monitor the ongoing performance, and make decisions to sell any assets.
This fee may also include investor relations and fund administration costs, although normally these latter expenses are include in the administrative cost category.
Management fees can be structured in a variety of ways. In the majority of funds though, management fees are based on a percentage of AUM. For example, a fund may have a stated management fee of 0.60% AUM.
In general, the greater the amount of work required from the managers, the larger the fee. So there can be a wide disparity in management fees between funds.
Actively managed funds require more work than passive funds.
Funds that focus on niche markets or areas with relatively poor public information on companies also require greater effort in analyzing and selecting investments.
Funds requiring complex trading strategies tend to need more work than simpler strategies.
When comparing MERs or the management fee itself, always make sure you compare apples to apples.
For example, it might make sense that a management fee between two Africa international equity funds is 2.10% AUM versus 2.00% AUM. One would expect that funds of similar size, investing in the same asset class and region, to have relatively equal MERs (if not, you need to find out why before investing).
But it may make less sense to compare these funds against a U.S. large cap equity fund. The U.S. fund likely has better available research and corporate information on possible investments than do the companies based in Africa. It is reasonable to expect greater work being required to assess African companies. Greater work equates to higher fees.
Or perhaps the U.S. large cap fund has AUM of $10 billion. In comparing that with another fund holding only $100 million in assets, you may expect the larger fund to have a lower MER. For the simple reason that the bigger fund has more assets against which to spread its costs. Would you expect a fund with $10 billion in assets to require 100 times the management costs versus a $100 million fund?
Popular in hedge funds, you may also see performance based management fees on top of the standard charge. The performance fee may be based on on profits earned (e.g., 20% of all positive returns), on profits above a designated “hurdle rate” (a benchmark return such as the U.S. Treasury Bill rate, the S&P 500, etc.), or on profits above the “high water mark” (the highest previous return for the fund).
Administrative Costs
Administrative costs cover the back-office costs of operating a fund.
These may include: legal fees; accounting and auditing expenses; record-keeping and regulatory filings; shareholder and other statement preparation and distribution; custody services; staff salaries; rent and utilities on office space.
One would expect that greater administrative costs would be attached to larger funds. And that is probably a fair assumption in hard dollar terms.
However, as administrative costs are also reported as a percentage of AUM, larger funds may appear to have lower costs. This is an advantage of aggregating one’s capital in a mutual fund. You can spread out the administrative costs amongst many investors, creating an economy of scale that benefits you. Same as with fund management fees.
Perhaps ABC fund has annual administrative costs of $2 million. DEF fund has administrative costs of $3 million; 50% greater than ABC. But DEF has assets of $3 billion, whereas ABC only has assets of $1 billion. This equates to 0.2% of AUM for ABC, but only 0.1% for DEF. While ABC has lower administrative costs in absolute dollars, DEF has a better ratio.
Note that while this ratio might be interesting, it really tells us nothing as to whether either ABC or DEF is well-managed.
The best one can do is to compare the costs to funds of similar size and in the same investment categories.
Marketing Costs
Often mutual funds break out their marketing and distribution expenses.
In the U.S., these fees are known as 12b-1 fees. The designation refers to a relevant section of the Investment Company Act of 1940.
In the U.S., a maximum of 1.0% of the fund’s net assets may be used for marketing the fund.
It may seem strange to pay an annual fee to market a product that you already own. The belief is that by marketing a fund, it will attract new investors. New investors will add to the asset base, creating an economy of scale for the administrative costs. This will result in net savings for shareholders.
I have not seen any evidence to support this contention. And in this age of mutual fund investing, investors look primarily at performance and costs when screening funds. What they may see on a television advertisement or hear about from a sales representative is way down the list of review points. Or it should be.
I consider these costs a waste of money for investors and suggest you do the same.
Total Expense Ratio
Neither the sales charges nor fund transactional costs are included in the MER.
The sales charge (i.e., commission or load) is not a fund expense. Rather it is a direct cost to the investor. It makes sense that it is not included in the fund’s cost structure. Same if you have to pay a brokerage fee to buy or sell the fund.
Transaction costs incurred by the fund when buying or selling fund portfolio investments (e.g. brokers’ commissions, spread differences, etc.) are expenses of the fund.
Total expenses are calculated by taking the management expenses (management fee, administrative, marketing) and adding in the transaction costs.
To obtain the total expense ratio (TER), simply divide the fund’s total expenses by the fund’s total assets (AUM). As stated above, many jurisdictions now blend MER and TER, so you may only see the MER stated. If so, it should also include these internal trading costs.
To further complicate matters, sometimes TER relates only to Trading Expense Ratio. So it is separate from, rather than cumulative with the MER. Anything to confuse investors. And yes, that is a goal of fund companies.
Internal Transaction Costs
In assessing funds, perhaps one fund has a relatively high TER versus its MER. That means the transaction costs are high. This can be due to poor order executions, high spreads between bid and ask prices, or high portfolio turnover.
High transaction costs may be a red flag when deciding to invest. Unless high frequency trading is the strategy.
If the fund is not doing a good job of executing trades, it may not be getting the best prices on its investments. It may also be paying too much in commissions. Both of these negatively impact returns.
High turnover means more frequent trades (and costs), which impairs profitability (unless that is the strategy).
High turnover may indicate that fund management lacks confidence or patience in their investment selections with all the selling of current holdings and replacement with new assets. This could be a warning about their future performance.
In some instances, it may indicate churning. That is, excessive trading within an account to drive up brokers’ commissions. Less a problem with mutual funds than in other circumstances (e.g., managed accounts), but it can still occur.
Finally, every time an investment is sold, there may be a tax implication for fund shareholders. Generating capital gains too early can accelerate the shareholder’s personal tax obligations and hurt compound returns.
Conclusion
First, when assessing fund costs, always compare like funds. Size, style, geographic region, asset classes, etc., they all impact the cost structure. Compare within the category in which you wish to invest if you want meaningful analysis.
Second, all else equal, choose funds with the lowest expenses. Unless you truly believe that a higher cost fund will generate superior net returns than a lower cost option, stick with the lowest cost possible.
Of course, that is not to say that you should invest in under-performing funds simply because they are cheap. But do place a heavy emphasis on costs when you do your total analysis.
Remember, future returns may or may not be the same as past performance. But there is a high probability that the cost structure of a fund will be consistent in years to come.
As we saw above, what may seem like small differences in costs will create substantial variances in investor wealth over time due to compound returns.
Make your money work for you.
Maximize the amount invested and earning actual returns.
Minimize the money you pay to others and receive no return on.
by WWM | Mar 21, 2018 | Mutual Funds
We previously reviewed the perceived advantages of investing via mutual funds. Funds are a great way for investors to build well-diversified portfolios and meet long-term investment objectives.
However, there are potential downsides. Not necessarily negatives, but areas investors need to be aware of and take measures to protect themselves against.
This is why we diverted to the concept of compound returns over the last few posts. How time horizon, cost structure, and rate of return can greatly impact long term wealth accumulation. Even 1% here or there can alter asset growth.
We will consider how mutual funds (or any investment) may negatively impact your annual net returns and thereby significantly impair wealth accumulation. Today, transaction costs incurred when buying and selling open-end mutual funds.
The Importance of Transaction Costs
As we saw in compound returns, every dollar you pay to someone else is a dollar of extra returns that must be earned just to break-even. And every dollar lost, is a dollar that cannot compound over time. A significant problem for investors attempting to achieve long-term portfolio growth.
Transaction costs can be a major expense when investing. Less so now that most investors use online brokerage accounts. $10 per trade is easier to handle than in the days of full service brokers.
As well, the introduction and proliferation of exchange traded funds has worked to reduce loads (and, as we will review later, expense ratios) in mutual funds.
Mutual Fund Transaction Costs
Funds may be subject to a sales charge when investors buy or sell shares or units of the fund. This transaction fee compensates brokers or internal fund salesmen for selling investors the fund.
The fee is known as the load or sales commission.
You may encounter front-end, back-end, or declining loads. Some funds may offer more than one option.
Note that different load options may result in other different terms or conditions. For example, a no-load fund may charge higher annual fees than the exact same fund with an upfront sales commission. Clearly understand the total fee structure, including ongoing costs, before choosing a load option.
Although similar to the broker’s commission when you trade a marketable security, be aware that a load is not a commission in that sense. If investing directly via the mutual fund company, there should be no broker’s transaction cost. Two different concepts.
Front-end Load Funds
A front-end load is paid to the mutual fund company when you purchase units or shares of the fund. In future, when you sell the investment, there is no load paid.
For example, on January 1, 2018 you invest $1000 in an global equity fund that has a a 5% front-end load and a closing net asset value (NAV) of $50 per share. You will pay $50 as a sales fee (5% of the $1000) and receive 19 shares of the fund with your remaining $950.
And yes, your fund has a lot of work just to recover the compound returns you will lose over time on that initial 5% load.
Back-end Load Funds
A back-end load is the opposite of a front-end load. Instead of paying a sales fee when you purchase shares of the fund, you pay a fee when you sell.
As you pay the transaction fee only at the end, back-end loads are also known as deferred loads or deferred sales charges.
Using our previous example, let us say that the 5% load is a back-end instead of front-end.
Had you invested $1000 in the global equity fund at $50 per share, you would receive 20 shares as the entire amount would be available for purchase.
Perhaps in 6 months the fund rises to a $60 per share NAV. You decide to sell your 20 shares and will have gross proceeds of $1200. As you now have a deferred load, you must pay the 5% sales fee. But not on the initial capital invested as in the front-end. Rather, you will pay on your gross proceeds. In this case, you will be charged $60.
The trade-off between the front and back-end loads is two-fold.
As you hope to experience appreciation in the value of the fund, you should expect to pay more for a back-end load with the same percentage fee than with a front-end load.
Because of the time value of money, the longer you hold the shares, the better the back-end load will look. If you intend to keep the investment for a long time and have a choice between equal fees, back-end funds should be the better option.
Declining Load Funds
Many back-end loads offer declining sales charges over time.
This is an incentive for investors to stay in the fund for longer time frames.
For example, perhaps the back-end load is structured as follows: 5% sales charge if sold within 3 years; 3% sales charge if sold after 3 years but before 7 years; 0% if sold after 7 years.
If you do not sell for at least 7 years, you will not be charged any fees.
In our example above, you consider selling your fund shares on December 31 in the years 2018, 2022, and 2027. The per share NAV on those three dates is respectively $60, $80, $100.
With a declining back-end load, you would pay a sales charge of $60 (2018), $48 (2022), and $0 (2027). The longer you hold, the better the deal. In this example, the dollar value sales charge decreased even though the total assets grew over time.
Often, declining loads appear very reasonable as many investors plan to hold onto funds for extended periods. However, be aware that the best of intentions often go awry. Personal circumstances may change and you may need to divest before the back-end load falls to nil.
As mentioned above, check to see how a back or deferred load may result in other charges or expenses. If you save money on the commission, you may just be paying for it under another guise.
No-load Funds
No-load funds do not charge a sales fee.
All else equal, no-load funds are more desirable to investors than any type of load fund.
Every dollar of investor capital goes to acquire shares of the fund. And every dollar of gross proceeds upon sale is due to the investor. None of the investor’s funds go to pay the salesman.
Of course, load fund salesmen will make compelling arguments as to why paying a sales charge to acquire a particular load fund is worth the fee.
While their load funds may be excellent, always keep in mind that the salesman is paid for selling the fund. I would add that “excellent” is a relative term. You need to assess whether the expected performance of the fund over time justifies paying someone for the privilege of owning it.
Many salesmen may be principled and want to find the you best fund for your needs. But some salesmen may push customers towards funds that provide them with the best sales charge. When dealing with people selling load funds, always be cautious as to their intentions.
Of course, the same caveat as with deferred loads is true for no-loads. You need to examine the other fund costs to see if you are paying a hidden commission.
Commissions on Mutual Funds
As I wrote above, a sales charge is not a broker’s commission. It is compensation from the mutual fund to the salesperson.
Open-end mutual funds are bought and sold directly from the mutual fund company. They do not trade on exchanges and you do not require a broker to transact trades on your behalf.
That said, to improve investor accessibility to mutual funds, many fund families allow investors to buy and sell funds through the investor’s brokerage account.
So if you purchase open-end funds (load or no-load) through your broker, you may be required to also pay a commission to the broker.
Not all funds are available through all brokerage firms. Some can only be purchased or sold directly through the fund company. Other funds may only be bought or sold through specific brokerage houses.
The number of funds sold can vary substantially between brokers. If you plan to invest in mutual funds, select a broker that offers access to a wide variety of funds.
As an aside, remember that we are discussing open-end mutual funds here. There are also closed-end funds. Closed-end funds do trade on exchanges and you do need to trade them through a broker. You do not buy or sell closed-end funds via the fund itself.
Closed-end funds do not charge any load. But they will always have a broker’s commission. And, as we shall see later, the same is true for exchange-traded funds.
No-Transaction Fee Funds
If you can buy a no-load mutual fund directly from the mutual fund company and not have to pay any broker’s commission, why would you ever buy a no-load fund through your broker?
Good question.
Outside of wanting to keep your investment portfolio all in one place (without having to set up accounts for your stocks and bonds at TD and your mutual funds in additional accounts at Fidelity and Vanguard), I do not have an answer for you.
I guess many other investors could not come up with reasons either.
Which leads to no-transaction fee funds.
Most brokers have arrangements with certain mutual fund companies to sell funds without charging a brokerage commission. This levels the playing field between fund companies and brokers and allows investors to access a variety of funds without incurring brokers’ fees.
There may be differences between brokers as to which fund families they will waive their commissions on. So check ahead before making investment decisions (or even choosing a broker to deal with).
The brokers give up their commissions to incent customers to buy funds through them. However, no-transaction fee program fund participants typically pay a fee to the broker each time a no-transaction fund is traded. This remuneration from the mutual fund company to the broker is a cost to the fund. And that cost is passed on to fund shareholders, thereby negatively impacting fund performance.
So even though you are not paying commission on the transaction, you will pay indirectly.
Load, No-Load or No-Transaction Fee?
I take a “best of breed” approach to investment recommendations. That is, I try to find the fund that best meets the needs and objectives of a client. My business model excludes my receiving commissions, etc. I have no vested interest in any funds. You pay my fee, you get what is best for you.
That said, with a few exceptions, I do not generally recommend load funds to investors. There are so many no-load options available that you have ample selection for all your portfolio needs.
Exceptions might relate to niche funds that specialize in small market segments where there are no suitable no-load alternatives. For investors starting out or simply wanting to create a well-rounded investment portfolio, I likely would not recommend niche funds anyway.
Exceptions might also relate to load funds with superior net long-term performance. Though this tends not to be the case. Research indicates there is no correlation between loads and fund performance. However, in assessing individual funds, a specific load fund might have superior returns over a similar no-load fund.
You will pay for a fund’s costs in one form or another. Just because you are not paying a sales charge does not mean you are not paying any fees. They may just be buried amongst other expenses. Always focus on a fund’s overall costs and its management expense ratio when deciding on the right fund.
One final comment. Sales commissions may be negotiable. It often depends on the fund company and the level of assets you intend to purchase or bring in. But if you do not ask, you will never get. And every dollar saved, is worth a lot more over time in your portfolio.
Okay, enough on mutual fund transaction costs.
We will take a further look at fund costs later.
Specifically, annual fund operating costs and the management expense ratio.
by WWM | Feb 21, 2018 | Mutual Funds
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.
by WWM | Feb 14, 2018 | Mutual Funds
We detoured from our review of investment funds to look at a few strategies and analytical ratios often used by investors.
In our Mutual Fund Introduction, we saw that there are an overwhelming number of mutual funds on offer. And that these funds cover the entire spectrum of asset classes and sub-classes.
How can investors possibly make sense of these investments? Truthfully, it is hard.
Today we will look at a few available mutual fund types.
Money Market
Money market instruments are short-term debt instruments (i.e., less than 1 year to maturity). Investments are considered extremely safe due to the nature of the fund investments.
Interest income is paid to investors.
While the returns are not high, they are better than what one would receive from savings accounts. And as the fund aggregates money from many individual investors, it can obtain higher returns on treasury bills and other short-term debt than a small investor could achieve on his own.
Money market funds may be available in foreign currencies. This may create foreign exchange gains or losses as compared with the investor’s domestic currency. In some cases, this can greatly enhance investor returns or possibly create losses.
Always take care when investing in money market funds – or any asset – that are not in your own currency.
Fixed Income Funds
You may also see these termed “bond funds”.
These funds invest in government and corporate debt. Some include preferred shares as well.
Within the fixed income style, there are many sub-categories.
Quality of Issuer
Some funds focus only on high quality debt issuers.
Other funds specialize in high risk issuers in the expectation of receiving higher returns. This latter group of non-investment grade fixed income instruments is known as “high yield” or “junk bonds”.
The quality of the issuer is based on ratings assigned by one of the bond rating agencies. For example, bonds with ratings below BBB by Standards & Poors or Baa by Moody’s are considered non-investment grade bonds.
Terms to Maturity
Some funds concentrate on specific terms to maturity. Perhaps only investing in bonds with maturities between 5 and 10 years. Or maybe only in bonds with over 20 years life remaining.
Or you may see “bond ladders”. These funds spread out maturity dates like rungs of a ladder to smooth interest rate and reinvestment risks.
Regardless of Type
Fixed income funds attempt to generate a steady cash flow of interest (or dividend) income to investors. Although the objective is income, there may be capital gains or losses as well.
As interest rates fall, the market value of existing bonds will increase. This can create a capital gain if the bond is sold prior to maturity. Should interest rates rise, bond prices will fall, causing a capital loss if the bond is sold.
Due to the underlying investments and longer maturity dates, fixed income funds should generate greater interest income than money market funds. However, in times of rising interest rates, money market funds may outperform fixed income funds if the fixed income funds experience capital losses. Something to watch out for when investing in fixed income.
Balanced Funds
Balanced funds try to provide a balance between security, income, and capital appreciation.
The funds invest in a mix of money market, fixed income, and equity instruments to achieve this objective. As a result, the fund generates both dividend and interest income as well as capital gains (or losses).
The asset mixture is defined in the fund’s stated objectives. They do not need to be “balanced” equally.
Combination of asset classes may be fixed (e.g., 5% money market, 35% fixed income, 60% equities) or have a range of maximum and minimum investment levels for each of the three classes (e.g. 0-10% money market, 20-50% fixed income, 40-70% equities).
Investment percentages may further be broken down into asset sub-classes. For example, if 60% is allocated to equities, perhaps 30% is United States, 25% Other International, and 5% Canada.
The fund’s prospectus will lay out the investment strategy and restrictions.
Do not confuse balanced funds with asset allocation funds.
Asset Allocation Funds
Although similar in nature, there is usually greater flexibility in an asset allocation fund. This allows the portfolio manager to take advantage of changes in the business cycle to maximize investments in an asset class.
For example, as the economy heats up, stocks will begin to rise and fixed income assets should fall in value. An asset allocation portfolio manager has the flexibility to shift the bulk of the portfolio assets into equities and out of under-performing asset classes like bonds.
Balanced funds have less or no leeway in altering the asset mix.
Because of the extra work involved by the asset allocation managers, it is normal for asset allocation funds to charge higher fees than similar balanced funds.
Target-Date Funds
Like balanced or asset allocation funds, target-date funds invest in multiple asset classes.
However, target-date funds automatically reset the portfolio asset mix based on the stated investment time horizon.
With a long maturity, investments are skewed towards riskier assets. As the maturity date gets closer, assets shift into less risky investments.
This is much like Life-Cycle funds (also known as “Aged-Based” funds).
We will consider these funds further when we look at investor profiles and strategies.
Equity Funds
The largest class of funds are equity funds. They also have the most sub-categories.
In general, equity funds strive for long-term capital appreciation. Some may also generate income, but that is normally a secondary consideration. The exception being equity income funds that specifically seek dividends.
Equity funds may be aggregated in a variety of ways.
Market Capitalization
They may focus on stocks of companies that have certain levels of market capitalization. Large cap or small cap equity funds are common variations.
Type of Company
They may focus on characteristics and style fits of companies.
For example, value or growth equity funds.
Some funds focus on companies that pay high dividends. Others on companies that pay no dividends.
Geographics
You will also see funds based on the geographic location of the underlying companies. These equity funds may be designated domestic, international, and global.
Domestic equity funds are those that contain stocks listed on stock exchanges in the same country as the investor.
International equity funds are those whose companies are listed on stock exchanges outside the investor’s country of domicile. International funds may also be called “foreign” funds.
Global equity funds may contain shares of companies from anywhere in the world.
For example, consider the Credit Suisse (CH) Swiss Blue Chips Equity Fund UB. It invests mainly in large cap companies located in Switzerland. Nestle, Novartis, Roche, UBS, etc.
As a Swiss investor, this would be domestic fund. To an Canadian investor, it would be an international fund.
In contrast, the Credit Suisse (Lux) Global Value Equity Fund BH CHF invests in a wider range of equities. Its scope includes “undervalued companies which are listed worldwide on regulated and accessible markets.”
Because it has shares of companies from both within and outside Switzerland, it is a global fund to a Swiss investor. And to a Canadian investor as well.
Sector
Within the broader categories, you may see smaller fund compositions, such as by industry or business sector.
For example, Fidelity offers equity funds that cover: Consumer Staples, Consumer Discretionary, Energy, Industrials, Telecommunications, Financial Services, Health Care, Materials, Natural Resources, Precious Metals, Technology, Utilities.
Countries or Regions
Funds also exist that narrow the geographic segments into regions and countries.
T. Rowe Price has a Global Stock fund. But they also provide more geographically focussed equity funds including: Africa & Middle East, Emerging European & Mediterranean, Emerging Markets, European, Japan, Latin America, New Asia.
Or you may even see subsets of subsets. A BRIC fund is a good example. This is an emerging market segment that includes only Brazil, Russia, India, and China. The four largest emerging markets.
Speciality Funds
Speciality funds are those that do not fit into one of the above boxes. Hard to believe, I know.
That said, some people include sector and regional funds as specialty funds.
Real Estate
In this category, you usually find investments in real estate companies or assets.
Some funds invest in operating companies that manage hotels, develop properties, etc.
Precious Metals
You may also see funds that invest in precious metals.
This can be achieved by investing in companies involved in precious metals. Often this includes indirect involvement, such as service companies.
It may also include direct investments in the assets.
For example, Tocqueville Gold (TGLDX) invests about 80% of its capital into shares of mining and related companies. But up to “20% of the fund’s total assets may be invested directly in gold bullion and other precious metals.”
Collectibles
Some funds allow you to invest in other exotic assets such as collectibles.
There are many funds that specialize in tiny market segments, including fine art and vintage wine.
I would caution investors with these unique types of funds. Usually the management fees are extremely high, the ability to liquidate one’s investment may be limited, and the investment time frame required may be substantial.
While collectibles may be useful for diversification, I would not recommend their purchase for most investors.
Environment, Social, and Governance (ESG)
A very popular investment niche over the last decade or so.
These funds invest in specific areas or exclude specific investments from their options in an attempt to be socially responsible or ethical.
For example, the Pax Ellevate Global Women’s Index Fund (PXWIX) employs “a global, index-based investment strategy designed to capture investment returns associated with gender diversity and women’s leadership.”
Or consider The American Trust Allegiance Fund (ATAFX). Its investment strategy seeks positive returns, while “avoiding companies involved in the alcohol, gambling, tobacco and health care industries.”
That is an overview of common fund categories. Over time, I will discuss these in more detail as we look at constructing diversified portfolios.