Introduction to Mutual Funds
You are faced with a dilemma. Burberry has just released its latest handbag priced at an exorbitant £1500. Your mother’s birthday is in two weeks’ time and you want to do a little extra this year, however, you haven’t saved enough. Disappointed, you turn to your father who suggests the idea of contacting close relatives to pool in money for the gift. After two weeks, you head straight to the nearest Burberry and buy that handbag. The look on your mother’s face is priceless.
Stemming from this idea is the concept of mutual funds. They are a passive investment vehicle wherein, multiple investors of different sizes ‘pool’ money into a war chest. This war chest is handled by a fund manager whose duty is to increase the investors’ returns by investing in various stocks, bonds and indexes. Collectively, a portfolio is created allowing investors to ‘buy in’ to the performance of the portfolio.
When compared to buying stock, one does not get voting rights in a mutual fund. The fund manager decides all investments for the portfolio. Consequently, an investor can buy an asset from the fund which is a proportion of a combination of stocks, bonds and indexes of the fund itself. This gives rise to the concept of Net Asset Value (NAV), which represents a fund’s per share market price. For example:
- Assume that the fund invests $50 million a year across 10 million shares
- It has liabilities of $10 million
- The fund’s NAV would be $4 ($40 million/10 million)
Why Would One Invest?
Mutual funds are well diversified and can be bought into with no minimum amount. However, their most important characteristic is that they are passive; the fund manager is responsible for generating returns primarily through capital gains and dividend payments.
Suppose the portfolio’s net value is $40 million. Over 3 years it rises to $60 million, representing a 50% increase in net value. You have purchased 1250 shares of the fund at a NAV of $4, resulting in a total investment of $5000. Since the NAV has risen to $6 after 3 years, your initial investment has risen by 50% to $7500. You decide to redeem your stake after the redemption period and pay a fee of 0.5%, resulting in a total profit of $7462.5.
Suppose the mutual fund holds Pfizer shares which have an annualized 5% dividend payout. Pfizer makes up 10% of the fund’s portfolio and you have invested $10000. Therefore, you have a $1000 stake in Pfizer through the fund. A 5% annual dividend payout would give $50 in return.
Types of Mutual Funds
Mutual funds are quite diverse in a categorical sense. Funds for technology, healthcare and real estate are quite popular. However, the 3 most common funds are:
1) Money Market Funds
Invest in short term fixed income securities like bonds, T-bills and commercial paper. They give low returns and are usually a safe investment.
2) Index Funds
The sole purpose of these funds is to track indexes like the S&P 500. The 3 largest mutual funds in the world fall in this category with portfolios valued at $350 billion and above. They aim to replicate at least 80% of the portfolio based on the S&P 500. They have shorter redemptions and fees as the fund manager does not have to make as many investment decisions.
3) Equity Funds
Stock is the main focus of these funds. While the risk is high, these funds aim to outperform indexes and promise a high rate of return. They are only accessible to high-net-worth individuals as the fees and NAV’s are quite high. They aim to specialize in growth and large-cap stocks.
Similar to trading commissions, mutual fund managers charge fees for their investment knowledge. Apart from the redemption fee, a fund management fee is levied which is lower than 1%. Generally, one must hold his mutual fund positions for the long term (3+ years) to realize any actual gains. High capital gains will be subject to tax inefficiencies even during the time of redemption which when added on with the redemption fee can neutralize gains on very small investments.
Where You Can Start
Firstly, identify the type of mutual fund you want to invest in. Vanguard has a great tool that gives you an in-depth look at fund characteristics. Secondly, open up a trading account that lets you invest in public-traded funds. Fidelity, Hargreaves Lansdown and HSBC UK are some of the most popular brokers with low management fees and flexible redemption timelines. Thirdly, choose a deposit amount. This can be any amount as public mutual funds do not have restrictions. Finally, invest in the fund by placing a trading order through your respective brokerage. Any gains or dividends will be sent to your linked account net of expenses and tax every three months.