What are mutual funds?
Mutual funds, also known as managed investments, allow you to pool your money with that of many other investors so that the mutual fund can buy a wide range of investments managed by a professional team. This includes investments which may not ordinarily be available to you through direct investment such as large commercial properties and corporate bonds.
Direct investment versus mutual funds - 'pros' and 'cons'?
Once you have decide to invest, you have a choice of investing directly or through a mutual fund. Which method is appropriate may well depend on your individual investment needs, however, using professional fund managers can generally provide better returns over the long-term.
Fund managers tend to outperform individual investors because:
Their portfolios are constructed using a defined and consistent investment philosophy;
Fund managers have a far greater access to quality information including company contacts, competitors and customers than do individual investors;
Fund managers employ full-time investment professionals to monitor investment markets and the way economic developments affect these markets;
The size of their portfolios generally means that fund managers can more easily reduce risk through greater diversification. They can also reduce risk by implementing sophisticated risk-management techniques involving the use of derivatives; and
Fund managers have the economies of scale to reduce expenses through lower transaction costs. For example, fund managers generally pay much lower commissions to stockbrokers.
For whom are mutual funds most suitable?
Mutual funds are a simple and convenient investment option for people who have a long-term investment horizon but do not have either the time, desire, or expertise to invest directly in financial markets.
Mutual funds can be particularly suitable for smaller, first time investors as they offer the opportunity to establish a broadly diversified portfolio of assets with a relatively small amount of money.
However, larger investors can also benefit from mutual funds as they provide access to the expertise of professional investment managers.
When you invest in a mutual fund, your money buys 'units' in that fund, at a price that is struck for that particular day. Over the period in which you invest, the mutual price will move up and down as the value of the investments with the mutual fund rise or fall.
Returns from a mutual fund are typically calculated based on movements in the bid (or withdrawal) mutual price and assume any income distributions paid to investors are reinvested in the fund as additional units.
The Secret to Wealth
Whether you want to invest in shares or across a broad range of asset classes, mutual funds provide you with one benefit that can be very hard for individual investors to achieve - diversification.
Many people invest but only some become wealthy.
The mistake many people make when investing is that they treat their investment as saving.
Saving Versus Investing
So what is the difference between saving and investing? Saving is what you do to build up funds for something, like a holiday, and when you have the amount saved you withdraw your capital from your investment and spend it on the holiday. After the holiday you have nothing left, and start the process all over again.
But building wealth is different. People who want to build wealth invest their money for the long term in 'growth assets' such as shares and property.
Their strategy is to spend the income that the investment produces, but to leave the capital invested. They don't withdraw the capital, so it stays there growing and compounding, and producing more and more income each year.
If you do this it will take you quite a while longer initially to get to your investment goal, but in the long run you will find that the extra wait has been worth it. As the years go by, you will have an increasing additional income stream from your investments and your standard of living can rise accordingly!
Should I continue to retain capital in retirement?
Retaining your capital is a good strategy to use for wealth accumulation. Of course when you stop working later in life, your strategy may change. At that point it can often be beneficial to start drawing on some of your capital as well, whilst still ensuring that it will last for as long as you need it.
Investing for a specific goal
When investing money, many people have a specific goal in mind. If this is the case for you, you need to decide what time frame is attached to that goal - short term, medium term or long term?
Examples of investment goals are:
Investing a specific amount
Rather than having a particular investment goal, some people may just be wanting to invest a certain sum of money eg. an inheritance. If you are in this situation, you need to decide what you want from that money.
Do you want to use the money in the next year or two? (in which case you are a short term investor). Or do you want a regular income? (you will need medium term income-producing investments). Or do you want it to achieve capital growth over a long period of time, and are willing to take a long term view?
The time frame of your goals will determine how the money should be invested.
A short term investor would be more likely to choose a more conservative investment like cash, to ensure that their capital is available in the next 1-3 years when they need to access it.
A long term investor would be more willing to invest in 'growth assets' such as shares, as they do not need to access their capital for at least 5 years, so are less concerned about short term ups and downs. They recognise that the potential returns are much higher in growth investments, and if they are held over the long term the risk is reduced.
A financial adviser can assist you to understand the types of investment most suitable for your goals.
General Risks of Investing in Mutual Funds
Any investment carries with it an element of risk. Therefore, prior to making an investment, prospective investors should consider the following risk factors.
Investors should be aware that by investing in a mutual fund, there is no guarantee of any income distribution, returns or capital appreciation.
Any purchase of securities will involve some element of market risk. Hence, a mutual fund may be prone to changing market conditions as a result of:
In addition, the following risk factors should also be considered:
There are many specific risks which apply to the individual security. Some examples include the possibility of a company defaulting on the repayment of the coupon and/or principal of its debentures, and the implications of a company’s credit rating being downgraded.
Liquidity risk can be defined as the ease with which a security can be sold at or near its fair value depending on the volume traded in the market.
Inflation rate risk is the risk of potential loss in the purchasing power of your investment due to a general increase of consumer prices.
If a loan is obtained to finance the purchases of units of any mutual fund, investors will need to understand that:
This refers to the current and prospective risk to the mutual fund and the investors’ interest arising from non-conformance with laws, rules, regulations, prescribed practices and internal policies and procedures by the manager.
The performance of any mutual funds is dependent amongst others on the experience, knowledge, expertise and investment techniques/process adopted by the manager and any lack of the above would have an adverse impact on the fund’s performance thereby working to the detriment of Unit holders.