Today, I will be talking about Mutual Funds (MFs)/ Unit Trusts (UTs). It is effectively own a pool of stock managed by a fund manager.
By definition:
A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors - Investopedia
A unit trust (or “mutual fund”, as the wacky Americans call it) is a fund where multiple investors pool their money. A fund manager takes that pool and channels it into a whole bunch of different investments. -Money Smart
Here are the keywords:
1. A pool of money - UTs get their capital from a pool of investors
2. Invest in securities (Stocks, bonds, money market instruments, and other assets) - buying assets to generate returns
3. Operated by managers - The assets are selected by professionals, they would decide when the purchase will take place, the portfolio allocations and how long to hold it for.
So... What is a Mutual Fund?
Essentially, imagine you and a bunch of other investors invest a sum of money. Through that, a manager of the fund would decide what stocks to buy, how much to buy, how long to hold. The manager's aim is to beat the market and generate returns for you. It may be in his interest to beat the market, as his salary may be pegged to how much he can outperform the market. This is unlike ETFs, where you are buying the market.
Now that we know what are Mutual funds, allow me to elaborate on their advantages and disadvantages:
Advantages:
1. Quick Diversification - You buy into all the stocks under that fund.
2. Professional Management - By paying the fees, you can have a professional team of managers/ analyst that is working to maximise your profits.
3. Reinvested Dividends - Some funds allow for your dividends to be reinvested and purchase it at a lower price. This would further increase the units that you are holding.
4. Low barrier to entry - Similar to ETFs, mutual funds are relatively cheaper to invest. You can even do a $100 investment every month.
5. Potential to beat the market - As mutual funds would steer away from the market index, this would give them the potential to do better than the market.
Disadvantages:
1. High expense ratios and Sales charges - Research has shown that a high expense ratio would negatively impact your returns. The picture below shows the correlation, not including the sales charges.
2. Bad fund Management - Some fund managers may use techniques to make their funds appear to be doing better than it is.
3. Limited trade execution - As you can only buy and sell units of a mutual fund at the end of the trading day. You might not be able to execute buy and sell orders immediately.
4. Potential to do worse than the market - As mutual funds would steer away from the market index, this would also give them the potential to do worse than the market.
How to determine a good mutual fund?
This would be tough to write about. There is a module in my university that talks about this. Students that went through that have to research and find 3 mutual funds based on criteria and present what mutual funds they think will perform well.
Thankfully, I didn't have to take that module. But here are things that I found from my research:
1. The mutual fund's investment style:
If your focus is on receiving dividends, you shouldn't be looking at growth mutual funds. Likewise, if you are seeking capital appreciation, you should not be looking at income mutual funds. If you have a long time horizon and the mutual fund seeks to make returns in a short time, that would be a conflict in the investing approach. You should choose one that suits your style.
2. Size of the fund:
Warren Buffett has famously said that if he only had a mere $1 million to invest, he could guarantee 50% annual returns. He then explained that having a large fund size would hinder the purchasing process. This is as your investment would make a substantial impact on the company's market cap - Imagine you have $1 billion, you want to find 5 companies to invest in. You would be limited to companies whose values are more than $200 million. Hence, even if there are good stocks that are under $200 million, you would not be able to buy them.
Hence, a mutual fund needs to be small enough to be flexible in taking advantage of smaller companies. aka. Flexibility.
3. History of the fund manager and his trading frequency:
A fund manager that has been managing the fund for a long time may indicate that he knows the values of the assets that he is managing. A lower trading frequency would indicate that he is adopting the buying and holding approach to investing and that he is confident in the stocks that he chose.
4. The number of holdings:
A larger number of holdings would indicate diversification, this would generate a more consistent return in the long run. This is important as this is one of the advantages of mutual funds - quick diversification
5. Fees and Expense ratio:
You would want the fees and expense ratio to be as low as possible. As we can see the correlation between fee, expense ratio and the return that you receive from your mutual funds.
6. Outlook on the market/sector that fund is investing in:
If you believe that the market/sector that the fund is investing in has the potential to do well in the future (ahem, China, India, Indonesia, etc), you can invest in those markets. Emerging markets are generally less efficient and mutual funds usually perform better under those conditions.
Thoughts and opinion:
As we have discussed in the SPIVA scorecard, mutual funds are unable to outperform the market in the long run. Fees and expense ratios are one of the reasons that contribute to this observation. Furthermore, I am a believer of the Efficient Market Hypothesis, especially in the efficient US market, no investor can consistently take advantage of the market. Plus, the success of a fund in one year does not translate to the next year (from the SPIVA scorecard), which means it is extremely hard for you to choose a fund that will earn you higher than market returns.
Yes, there are fund managers that consistently do well and deliver higher-than-market returns to their investors. They are Peter Lynch (who wrote a book on how to perform better than fund managers) and......
Sorry, I only know one mutual fund manager that was really successful and popular.
If you're thinking of Ray Dalio and Warren Buffett, no. They are not mutual fund managers. they are hedge fund managers. This is a topic for a different day.
Personal Portfolio:
As you can see from the way that I wrote, I sincerely do not believe in the value of mutual funds. It is my belief that mutual funds still exist as a lot of money is paid in the advertisement and marketing to sell to the public. As we become more financially savvy, we should see a decline in mutual funds. Just like in the US.
With that,
I end today's topic.
Stay vested, Stay frugal my friends,
Dionysius
Taken from the morningstar white paper titled "study on investing expense ratio"
Sources:
https://blog.moneysmart.sg/invest/unit-trust-singapore-invest-guide/
https://www.dbs.com.sg/personal/investments/unit-trusts/get-to-know-unit-trusts
https://www.valuechampion.sg/introduction-funds-singapore-what-are-unit-trusts-and-etfs
https://www.moneysense.gov.sg/articles/2018/10/unit-trusts-guide-to-pricing-and-fees
https://www.investopedia.com/terms/m/mutualfund.asp
https://www.sec.gov/reportspubs/investor-publications/investorpubsinwsmfhtm.html#Common
http://oreillywa.com/wp-content/uploads/2017/08/morningstar-study-on-investing-expense-ratios-2016.pdf
https://www.thebalance.com/how-to-choose-the-best-mutual-funds-2466456
https://www.investopedia.com/investing/how-pick-best-mutual-fund/
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