Unit Trusts or Mutual Funds
Overview… Here’s an interesting fact… There are more mutual funds in America than there are stocks on the New York Stock Exchange! If that seems a bit strange to you, it does to the Sage too! Let’s try to figure out what the “fund appeal” is all about…
Introduction to Mutual Funds A mutual fund is simply a collection of stocks and/or bonds. The term “Unit Trust” is more familiar in Singapore…but the terms can be used interchangeably. Most mutual funds are “actively managed,” meaning the mutual fund shareholders, through a yearly fee, pay a mutual fund manager to actively buy and sell stocks or bonds within the fund. Though you would think that mutual funds provide benefits to shareholders by hiring alleged “expert” stock pickers, the sad truth of the matter is that the vast majority of mutual funds underperform the average return of the stock markets they participate in. Over time, because of their costs, approximately 80% of mutual funds will underperform the stock market’s returns. Currently, most mutual funds do not make their fees very easy for shareholders to understand. On the whole, the average mutual fund returns approximately 2% less per year to its shareholders than does the stock market in general. The stock market’s historical returns are roughly 11% per year, but managed mutual fund shareholders as a group can expect to see any return reduced by the approximate costs imposed by the funds. Many American investors (and gaining momentum globally now) have turned to “Index Funds” which simply turn over management responsibility to a computer program which tracks a popular stock index, such as the S&P 500 Index, or the Russell 2000 Small Stock Index. In fact, Index funds are now some of the largest funds in America managing billions of dollars for investors…the largest being offered by Vanguard and Fidelity Mutual Fund Companies tracking the S&P 500 Index.
Advantages of Mutual Funds
Diversification. Buying a mutual fund provides instant holdings of several (or more often, thousands) different companies.
Liquidity. Like individual stocks, a mutual fund investment can be converted into cash upon your request.
Disadvantages of Mutual Funds
The Wisdom of Professional Management. That’s right, this is not an advantage. The average mutual fund manager is no better at picking stocks than the average nonprofessional, but charges fees as though she is! (of course, when the sage one day manages a small-cap fund in Singapore, it will be the exception to all the rules! You’ll see one day soon… stay tuned!).
No Control. Unlike picking your own individual stocks, a mutual fund puts you in the passenger seat of somebody else’s car.
Dilution. Mutual funds generally have such small holdings of so many different stocks that insanely great performance by a fund’s top holdings still doesn’t make much of a difference in the mutual fund’s total performance.
Buried Costs. Many mutual funds specialize in burying their costs and in Hiring salesmen who do not make those costs clear to their clients. FUND CLASSIFICATION
Mutual funds now come in every possible size, shape, and color. Although the selection in Singapore is a far cry from the US, let’s still take a moment to review the types…
Bond Funds Bond mutual funds are pooled amounts of money invested in bonds. Bonds are IOUs, or debts, issued by companies or by governments. A purchaser of a bond is lending money to the issuer, and will usually collect some regular interest payment until the money is returned. Usually the amount of interest paid (the coupon) is fixed at a set percentage of the amount invested, thus, bonds are called “fixed-income” investments.
Balanced Funds Balanced funds mix some stocks and some bonds. A typical balanced fund might contain about 50-65% stocks and hold the rest of shareholder’s money in bonds. It is important to know the distribution of stocks to bonds in a specific balanced fund to understand the risks and rewards inherent in that fund.
General Equity (Stock) Funds: Styles & Sizes Stock or equity mutual funds are pooled amounts of money that are invested in stocks. Stocks represent part ownership, or equity, in corporations, and the goal of stock ownership is to see the value of the companies increase over time. Stocks are often categorized by their market capitalization (or caps), and can be classified in three basic sizes: small, medium, and large (reference our class on Analyzing Stocks). Many mutual funds invest primarily in companies of one of these sizes and are thus classified as large-cap, mid-cap, or small-cap funds. Further categorization of funds could be on investment style of the fund manager, such as value funds, growth funds, or income funds
International or Global Funds International funds invest in companies whose homes are beyond the fair shores of this great nation (whatever nation you happen to be in while reading this… and assuming it has a shore). Global funds invest in both stocks of their own nation, and those of others, and especially in large multinational companies that span many national borders with their globally recognized brands. In general, international and global funds are more volatile than domestic funds (at least that is the history of American funds… far less data today on Singapore Unit Trusts).
Sector Funds Sector funds invest in one particular sector of the economy: technology; financial, computers, the Internet, llamas. (Just joking. No one has yet started the Llama Fund, thought its only a matter of time.) Sector funds can be extremely volatile, since the broad market will find certain sectors very attractive and very unattractive-often in rapid succession.
BUY AN INDEX FUND
Until the Singapore Stock Sage is able to start his Singapore Small-Cap “Sage Fund,” you little aspiring sage students are going to have to use your own…
That’s right, use your brain! “BUY AN INDEX FUND”. Sound simple? Sound like aiming too low? Tempted by all the advertising from local banks (and soon Brokers)? Simple is good… just remember… Almost all actively managed equity mutual funds over time lose to the market averages. And those funds that do beat the market’s return typically do so for only a very short period of time, and then quickly reverse course. (A few exceptions from very “Sagely” managers like Peter Lynch of the Fidelity Magellan Fund and others we’ll study in detail in our Sagely Investing Strategies class later.
Stock index funds seek to match the returns of a specified stock benchmark or index. An index fund simply seeks to match “the market” by buying representative amounts of each stock in the index, rather than paying a manager to make bets on individual stocks, sectors, or investment strategies. Index funds do not even attempt to beat the equities market, they simply seek to come as close as possible to equaling it. The key to the unquestioned superiority of index funds is their extremely low expenses-they charge very low fees for providing the market’s return.
The largest and most well-known index fund is the very first index fund, the USA-based Vanguard Group S&P 500 Index Fund. This fund nearly matches the returns of the Standard & Poor’s 500 Index, and over the last ten years has beaten the performance of over 90% of all mutual funds.
Around the world today, there are a wide choice of indices…and thus an ever-growing choice of index funds. These index funds covering their respective market segments (small-cap, mid-cap, large-cap) or their respective market regions (USA, UK, Latin America, Brazil, Mexico, China, India, or Singapore) will in all likelihood outperform most managed funds that invest in the same segments of the market
One caveat though. Due to the recent popularity of index funds, several fund companies are charging higher fees than necessary. If you’re considering an index fund (and you definitely should until the Sage Fund emerges), always remember to compare its expense ratio (see below) against other similar index funds.
Understanding Fund Fees Mutual funds charge fees. Huge fees! Outrageous fees! As a group (though there are certainly individual exceptions) managed mutual funds appear to charge the highest fees they can get away with, and they charge these fees in the most confusing manner possible. There is a solution for this, and, as you might have guessed, it goes something like this: “Buy an index fund.”
Should you wish to explore the crazy and bizarre world of mutual funds beyond the index fund, make sure that you know exactly what fees you are paying. Here’s the skinny on them…
A mutual fund’s expense ratio is the most important fee to understand. The expense ratio is made up of the following: The investment advisory fee or management fee is the money used to pay the manager(s) of the mutual fund. On average, this fee is about 0.5% to 1.0% annually of the fund’s assets, and is seemingly necessary to make sure that the manager of the fund can be very well-dressed at all times and is able to go on exotic vacations and own a new Mercedes each year. Administrative costs are the costs of recordkeeping, mailings, maintaining a customer service line, etc. These are all necessary costs, though they vary in size from fund to fund. The thriftiest funds can keep these costs below 0.2% of fund assets, while the ones who use gold engraved paper, colorful graphics, and phone answerers with high-falutin’ accents might bring administrative costs above 0.4% of fund assets.
The term “Broker” originally was applied to early wine traders… today it is associated with those professionals who shamelessly push stock transactions
You don’t really need to concern yourself with how these components of the expense ratio are divided. You just need to know the bottom line. Again, the most important question that you should always determine about your mutual fund is, “How high is the expense ratio?” And remember, for actively managed funds, the average is about 1.5%
Meanwhile, in the wonderful world of index funds, the expense ratio is typically around 0.25% and does get as low as 0.19% for the king of all index funds-the Vanguard S&P 500 Index Fund in America. Lesson: Unless your fund manager is especially “Sagely”, it is best to replace him with a computer program!
Finding the Expense Ratio The expense ratio for each and every publicly traded fund must be revealed in the “fund prospectus”… read it carefully little Sages. The fund company will often have a web site to advertise its funds, and these sites often have a section which reveals fees in detail.
LOADS refer to the sales charge many funds use to compensate the broker for his or her “services” in selling the fund to an investor, and this is in addition to the annual expenses discussed above. “No-Load” funds simply are those funds that are sold directly to the investor, rather than through a middleman. The recent explosion of the no-load funds in the US gives investors all the fund choices they need to maximize your potential in America. However, in Singapore nearly all funds charge 5+% loads. What’s particularly ugly about loads is that you pay them up-front! This means your Singapore fund manager only invests 95% of your money in the fund and keeps 5% the very first day… before the ink dries on your check you’re down 5%… and add in a 2% annual expense ratio, and you’re fund manager had better be “Sagely”, because he now has to beat the market by a whopping 7% for you to just break even!!!
Deferred Loads. Sometimes called “back-end loads,” are as bad as front-end loads discussed above, but they’re not as clearly labeled. These funds defer the sales fee until you leave the fund, but end up being as bad to your financial future as if you paid them up front. EXCEPTION… if the deferred load is used to encourage investors to hold fund shares longer-term, this gives the rather-sagely fund manager more flexibility on his investment strategies (can hold less cash for unexpected redemptions)… but even here, the deferred load should phase out after 2-years.
Level Loads Double Yikes! The worse case! These funds charge small front loads, and level loads every year thereafter. Although they may look like smaller fees, they take a huge bite out of investors returns over time.
Turnover Rate & Taxes A fund’s turnover rate basically represents the percentage of a fund’s holdings that it charges every year. A managed mutual fund has an average turnover rate of approximately 85%, meaning that funds are selling most of their holdings every year and replacing them with new holdings. Because buying and selling stocks costs money through commissions and spreads, a high turnover indicates higher costs (and lower shareholder returns) for the fund. Also, funds that have large turnover rates in the US cause large capital gains taxes for their clients (not an issue today in Singapore, as there is currently no capital gains taxation). A fund with a more reasonable turnover rate of 25% would be attractive for long-term investors… and an average index fund would have a turnover ratio of only 5% or less.
REVIEW THE FUND PROSPECTUS!
Little aspiring Sages… don’t invest blindly. If you insist on investing in managed funds, spend an hour or two to know what’s up with your fund of interest. The prospectus is required to spell out details on Fees, Objectives, & Risks. Be a good student and do your homework.
ONLINE RESEARCH
While these sites focus on US funds, you will find much of interest:
www.morningstar.net
http://smartmoney.com/si/tools/mfsnaps/
http://www.fundstyle.com
