Mutual funds are rapidly becoming the investment vehicle of choice for personal investors. In 2019, there are hundreds of thousands of equities from all around the world to choose from, so how can an everyday investor without the time or resources to effectively research all of them, make the right decision?
In the modern era, where the internet makes everything we say and do significantly quicker, investing directly in equities is becoming less and less attractive. Let’s say you hold some Apple shares, and while you are busy at work some negative news is made public, sending the value of Apple shares 10% downwards. You do not possibly have the opportunity to react to this in ample time, meaning you potentially miss out on a buying or selling opportunity.
This is where mutual funds come in. A mutual fund is essentially handing a pot of money to a fund manager and asking them to grow it for you. It is then their responsibility to use their expertise and experience to get you the best possible return on your investment within the agreed parameters.
If you are feeling unwell you visit a doctor. If your car is broken you visit a mechanic. We allow these professionals to use their expertise to solve life’s problems, why wouldn’t you do the same with your money?
How Do Funds Work?
A mutual fund is an investment managed by a company called a fund house. Fund houses generally offer several different funds, each managed by a team of experts. They pool together the capital of many individual investors and manage it as one portfolio. A fund is essentially a basket of equities, handpicked by experts, which you can invest in. It is the fund management team’s full time job to monitor and manage your investment. They will buy and sell parts of the portfolio on a daily basis, putting in the hours so that you don’t have to. As a retail investor with little or no time to check on your investments daily, it would be near impossible to achieve the level of portfolio management fund managers provide.
While the fund managers are responsible for managing your money, you still have a say in how it’s invested. Every fund has an investment objective which fund managers must adhere to. Before choosing a fund to invest in, it is important that you decide on the strategy you want to take. Do you think that the USA presents good investment opportunities? Are you interested in the growth of small companies in the UK? Or maybe you think the technology industry is the best horse to back at the moment. Even if you wish to invest solely in companies with good sustainability records, you can do so. Funds allow you to choose an approach you like and let someone else maximise your investment for you.
A fund manager simply uses the investment objective of their fund to filter down investment opportunities. They then study the chosen markets on a daily basis, selecting investments with the greatest potential to grow your money for you.
What type of funds can I buy?
There are several different types of funds available to investors. Each has different goals and will meet the needs of some investors, while not being appropriate for others.
This is a fund which invests solely in direct equities. This means that instead of having a holding in a company directly, you will indirectly be invested in several different companies. There is no restriction on how many equities this must be, some funds may prefer to work with a small number of equities while others may work with hundreds.
This is a fund which invests only in bonds. Bond funds are a great way to access the bond market without actually having to buy a bond. You can simply buy and sell units in the fund as it suits you, rather than having to hold a bond for a number of years.
A mixed fund is a combination of the two above. Bonds and equities are widely regarded to be inversely proportional, meaning when the value of one increases the value of the other decreases. This means a combination of the two is often an effective way to manage investment volatility. Depending on the risk appetite of the fund, it will have different bond to equity proportions.
Exchange Traded Funds
An exchange traded fund, more commonly known as an ETF, is an investment which tracks an underlying stock market. These are widely regarded as passive funds, as the fund manager does not actively decide where your money is invested. Instead, the fund manager will mirror the chosen global stock index. For example, if you invest in an S&P500 index tracker your money will be invested in the 500 biggest companies in the USA. If the S&P500 increases by 10%, so too will your investment. These are often a low cost option but do not allow fund managers to use their expertise in your favour.
How do I make money from a fund?
While the above fund categories focus on where your money is invested, you also have some options with regards to how you enjoy its growth. Funds often come in multiple share classes, so you can truly customise your investment to suit your needs.
An income fund is one which pays out some or all growth as a dividend. This is ideal for those who rely on their investments to supplement their income, such as those who may have retired. A fund may pay a quarterly, bi-annual or annual dividend, directly to your investment account for you to spend or reinvest.
The accumulator version of a fund is ideal for those looking to compound their growth. Instead of paying a dividend out to investors, this type of fund will continue to hold your capital and provide you with growth on your growth.
For example, let’s assume you have invested in an equity fund which focuses on American technology. If the fund makes 10% in year one, your investment value will increase by 10%. If you chose the income variation of a fund, some or all of that growth will be paid out to you. If you chose the accumulator variation, the full 100% you invested plus an additional 10% growth from year one will continue to grow in the second year.
In general, funds are priced once a day. At any time, you can choose to buy or sell a fund, your order will be actioned as soon as markets in your chosen region open for business. Most funds can be bought and sold on any working day throughout the year. There are some exceptions to these norms, such as funds with lock-in periods, but we do not sell complex investments like this at MeDirect.
How do I know which fund to choose?
If you aren’t an experienced investor, or you’ve never invested in mutual funds before, there are a number of ways to pick an investment which is right for you.
Firstly, you need to decide exactly what you are investing for. Is it a long term investment you are willing to take some risk with? Or is it an important investment for your children’s education or your retirement, which you would like to see grow gradually but don’t want to see too many fluctuations? Once you have decided on the level of risk you would like to take, you can begin to reduce your options.
Every fund on our platform is shown alongside an “SRRI” (Synthetic Risk and Reward Indicator). Funds with a low SRRI typically experience less volatility and as a result, the likelihood of short term capital loss and gains are reduced. Funds with a high SRRI experience greater volatility and a greater risk of capital loss and gains in the short term, but in general it is likely that they will generate better returns over a prolonged period.
Investors with a short investment time horizon (five years or less) should consider funds with a lower SRRI rating, whereas those with a longer time horizon may be able to afford to hold an investment through market volatility in pursuit of greater long-term returns.
Morningstar Star Rating
The Morningstar Star Rating is a system by which funds are marked against their peers or competitors. Each fund is sorted by category, so that they are only compared to funds with similar investment objectives. Their returns over 3, 5 and 10 year periods are compared with their peers;
- Funds in the top 10% of their peer group are awarded five stars;
- The next 22.5% are awarded four stars;
- The next 35% receive three stars;
- The next 22.5% receive two stars;
- The final 10% get one star.
This is a useful tool and is one of the most used metrics throughout the investment industry. If you know where you want to invest your money, using the Morningstar Star Rating will help you choose a reputable fund with good expected long term returns, without having to spend days comparing different options.
Morningstar Analyst Rating
It is impossible to predict what will happen in markets globally tomorrow, never mind in five years. For this reason, forward looking ratings are hard to find. SRRI and Morningstar Star ratings are both backward facing metrics, meaning they build their score on past performance.
One of the few forward facing tools is the Morningstar Analyst Rating. This is produced by Morningstar’s analysts and focuses on a fund’s competitive advantages against its peers. It looks at the way a fund is managed and analyses how likely it is to excel against their peers in the coming years. Funds are rated between Gold and Negative:
- Funds which Morningstar sees with the greatest competitive advantage are rewarded with a gold rating;
- Those with a strong but not significant advantage are given a silver rating;
- Those with minor advantages are rated bronze;
- Funds with no remarkable advantage or disadvantages are given a neutral rating;
- Funds which possess at least one flaw which is likely to hamper future performance are awarded a negative rating.
All of the ratings mentioned above are displayed alongside the funds we offer. Not all funds will have been rated across all three metrics, but any that have will be shown on our site.
What Are The Benefits of Investing in Mutual Funds?
Mutual Funds carry many advantages over other investments.
By investing in a mutual fund over a direct equity you are diversifying your portfolio significantly. If you hold the aforementioned Apple share and Apple go out of business tomorrow, you lose your capital. If you invest in a fund which invests in Apple and the same scenario unfolds, your money is safe and you may see a small reduction in value but only a matter of a few percent. The same applies to a reduction in the value of an equity; investing in a basket of equities rather than one directly significantly reduces the effect a single equity will have on your overall return.
Lower Costs and Removal of Minimum Investment Barriers
If you attempted to mirror the investments made by a mutual fund, you would quickly face difficulties. Firstly, you would have to have a large enough individual portfolio to clear the minimum investment for every single security. Then you would also have to pay entry (and potentially exit) fees for each equity. Even if this isn’t a problem, every time you rebalance (buy and/or sell) an investment, you would need to pay these fees again. By investing in a fund you remove all of these issues and costs.
Fund Manager Expertise
As mentioned previously in this article, one of the greatest benefits is the expertise of a Fund Manager. It is their job to study and follow markets, they are better poised than anyone to make decisions on where the best value or growth opportunities are. A mutual fund is a great way to access such expertise at a low cost.
There is no tie in periods for mutual funds. At MeDirect there are no exit fees either, although this is not the case everywhere. This means you are free to sell your investment at any time. This is a level of flexibility you do not get with equities or bonds.
What Are the Disadvantages of Investing in a Mutual Fund?
Loss of Control
While you are the one who selects a fund and choses how much to invest, once the money is invested, the fund manager is in control. You have no say over their individual investment decisions and forfeit the right to manage your investment security by security.
While diversification is a risk reduction tool, reduction of risk also means potential reduction of returns. As touched on in the ‘Advantages’ section, if an equity within a fund declines by 10%, you will not see your investment reduce by the same margin. On the other hand, if the same security sees a value increase of 10%, this will also not be reflected by the same margin in your investment.
Systematic and Sector Risk
Three key risks affect all equities: company risk, sector risk and market risk. The use of mutual funds minimises company risk (the risk of a company performing poorly or liquidating). Mutual funds will also drastically reduce sector risk (the risk that a sector performs poorly as a whole), unless they are focused on one specific sector only. The only risk which cannot be reduced by using a mutual fund, is systematic risk. This is the risk that markets as a whole decline. When this happens all equities will be affected. The global financial crisis in 2007/08 is a good example of this. Markets globally saw vast reductions and the use of a mutual fund can cushion this blow but cannot avoid it entirely.
Are Mutual Funds Right for Me?
Mutual funds are a good option for any investor who does not possess the expertise to maximise their portfolio alone. In fact, even those who do possess such skills are turning to mutual funds as an effective investment vehicle to provide enhanced returns with little or no input or effort from the investor themselves.
Mutual funds are a great option for anyone who wishes to build a diversified portfolio and has a medium-long term investment timeline. This is not easy to do on your own, and unless you are an investment professional who has time to spend hours each day managing your own investments, it is unlikely you will be able to match the portfolio management offered by the world’s finest fund houses.
How do I Invest in Mutual Funds?
At MeDirect we have a fund universe of hundreds of funds, over a variety of sectors and regions. We work with the biggest fund houses in the world to provide our clients with the best possible options to invest for their future. Our platform contains all the tools you need to make an informed decision which is right for you.
The above is for informative purposes only and should not be construed as an offer to sell or solicitation of an offer to subscribe for or purchase any investment. The information provided is subject to change without notice and does not constitute investment advice. MeDirect Bank (Malta) plc has based this document on information obtained from sources it believes to be reliable but which have not been independently verified and therefore does not provide any guarantees, representations or warranties.
MeDirect Bank (Malta) plc, company registration number C34125, is licensed by the Malta Financial Services Authority under the Banking Act (Cap. 371) and the Investment Services
Act (Cap. 370).