Mutual Funds – An Effective Investment Vehicle / Strategy?

As promised in my last article, Investing during a global recession, today we will explore one of the most important investment vehicles for individuals and institutions – mutual funds. Despite their popularity, mutual funds are often misunderstood or understood only in a limited extent, even by many individuals with mutual fund assets.

What are mutual funds?

Mutual funds are comingled or pooled investment vehicles through which investors gain access to securities like stocks, bonds, money market instruments and other assets. In a mutual fund, each investor has a pro-rata claim on the income and value of the fund, referred to as net asset value.

What are pooled investment vehicles?

A pooled investment vehicle is one in which many different investors (individuals, pension funds, corporations, university endowments, etc.) contribute money to the pool to be managed, often by professionals, to achieve specific investment goals or strategies.

There are various types of pooled investment vehicles, including the following:

1.  Mutual funds (to be discussed in this article)
2. Exchange traded funds (ETFs)
3. Separately managed accounts
4. Hedge funds
5. Private equity

The last three types (“c” to “e”) are somewhat out of reach to many individuals (for now) because they require a large minimum investment requirement. Investing in separately managed accounts require a minimum investment amount of around $100k in most countries. Hedge funds and private equity funds often require a minimum of up to $1m as a typical starting point.

Advantages of investing in or through mutual funds

If you are reading this and you have ever engaged in investing, whether in equity (stocks), fixed income (public or private debt, govt. securities, etc.) or real estate, you would have had to deal with the challenge of determining how to construct a portfolio, what asset classes to include in your portfolio, which specific securities to invest in, what the appropriate price for a security is in determining whether / when to buy and sell, etc.

Pooled investment vehicles such as mutual funds often help address some of the concerns that you may have had as an individual trying to invest intelligently, without the experience and skills of an investment professional or without the resources of high net-worth individuals or institutional investors.

Specifically, some of the most important advantages mutual funds are:

1. Ease of entry / low minimum investment requirement: mutual funds typically have very low minimum investment requirements. Some mutual funds can be assessed with minimum amounts that are as low as $15 (about five thousand Nigerian Naira);
2. Access to professional money managers: investments made in / through mutual funds are managed by professional money managers with the relevant education, experience and skills that you may not possess as an individual investor;
3. Diversification and risk reduction: most mutual funds invest in and hold numerous securities at a time, which tend to provide some diversification benefits to the overall portfolio. As an individual, you may not have the amount of resources (cash) required to achieve that level of diversification on your own;
4. Liquidity: positions in most mutual funds can be redeemed or sold with relative ease – in the event of an emergency, you could access funds invested in a mutual fund relatively easily, subject to the completion of an initial lock-up period;

What are the types of mutual funds?

As you can probably already tell, since a mutual fund is simply a vehicle through which investments can be made in different types of securities for the participants / investors, many different types of mutual funds can be created to address the needs and constraints (e.g., risk – return requirements, moral / ethical considerations, religious considerations, etc.) of specific investor groups. 

However, most mutual funds can be classified into four major categories, namely:

1. Money market mutual funds
2. Stock mutual funds
3. Bond mutual funds
4. Hybrid / balanced funds

What are Money Market Mutual Funds?

Money market mutual funds are perhaps the most popular types of mutual funds among young adults or professionals in the early years of their careers, particularly in an emerging market like Nigeria. Money market mutual funds invest in safe (risk-free / low risk) short term debt instruments, mostly government treasury bills (T-bills).

The reason for their popularity amongst young professionals is their relative safety. Because money-market mutual funds only invest in risk-free / low risk securities, you are almost always guaranteed that your capital will be preserved in nominal terms.

Another reason for their popularity is higher returns compared with interest on bank savings. Money market mutual funds have served as a substitute for bank savings for decades because they have returns that are often significantly higher than interest on bank savings. This is particularly true for emerging market economies with high interest rates. However, money market mutual funds are not usually insured the same way as bank deposits.

Liquidity has also been a major reason for the interest in money market mutual funds. Since they can be redeemed within one to two days after the initial lock-up period (usually 30 days for any new amount invested), invested sums can be accessed more easily and without penalties or fines than investments held directly in many short-term government securities.

Notwithstanding their popularity, money-market mutual funds have disadvantages too, including:

1. Low returns: since money market mutual funds invest mainly in low risk (low interest rate) government securities, the returns earned by money market mutual funds are often lower than the expected returns on most asset classes. Recall that the higher the amount of risk you take on any venture, the higher the amount of returns you would expect to be compensated for that risk, passage of time and inflation.
2. Management cost: your money being managed by professionals requires that the salary of these professional managers be paid out of the returns earned by the mutual fund. You are basically sharing the returns earned from investing in money market securities with the investment manager. 

For individuals, contingency funds held in case of emergencies may be invested in money market mutual funds, instead of in normal bank savings accounts (or underneath the mattress / bed J). Money market mutual funds offer higher returns, without materially diminishing the advantage of liquidity that bank savings accounts give.

In addition to contingency / emergency funds, cash savings made for short to medium term purchases / projects e.g., savings for a car, savings for tuition / school fees which are due in around two to five months, savings for other periodic investment outflows, etc., may also be invested in money market mutual funds, instead of in normal savings accounts.

Adopting money-market mutual funds as a long-term or major investment strategy (i.e., other than cash held for emergencies and savings for near-term projects described above) may not be optimal in the long run because of the risk-return characteristics of money-market mutual funds. More on this later.

What are Stock or Equity Mutual Funds?

Equity mutual funds invest primarily in equity securities. There are two broad classifications of equity mutual funds. There are actively managed mutual funds and passively managed mutual funds.

1. In actively managed mutual funds, the portfolio manager attempts to outperform the market – i.e., to earn returns that are superior to the returns of the market. Market here does not mean the entire / global stock market, it simply refers to a given section of the overall market specified by or for the investment manager as a benchmark, e.g., an index which shows the performance of a collection / group of stocks;
2. Passively managed mutual funds simply aim to replicate the performance of the index that they track. (passively managed mutual funds and exchange traded funds [ETFs]) will be discussed extensively in a later episode of the Podcast or in a later article;

It is easy to get obsessed with the details so I will skip most of them to focus on the basics. One important point to note regarding equity mutual funds is that, because they invest primarily in equity securities, they have higher risk (compared with other mutual funds) and higher expected returns.

Expected returns do not always reflect “actual” returns. Actual returns depend on the skill of the manager, the overall business environment and the performance of the market, and as a result, returns earned by equity mutual funds (or equity securities generally) may trail returns earned by other asset classes / mutual fund types (e.g., fixed income) in the short to medium term. In the long run, however, equity mutual funds (and underlying equity markets generally) tend to outperform other traditional asset classes.

Some equity funds retain some, usually small, portion of their holdings in fixed income securities, for diversification and risk management. For example, the Stanbic IBTC Nigerian Equity Fund invests only about 70% of its assets in Nigerian equities, and about 30% in fixed income securities.

Lock-up periods for equity mutual funds are often longer than for money market mutual funds, but like money market mutual funds, redemption is also possible within a short time period with equity mutual funds. Redemptions are made at net asset value (NAV) per share, which considers the total value of securities in the portfolio at the end of the trading day, divided by the number of shares or units of the mutual fund that are in issue.

If the portfolio manager of an equity mutual fund is skilled and the market performs well, equity mutual funds tend to earn great returns. However, during poor economic conditions as we have in 2020, even with a skilled portfolio manager who outperforms the market / benchmark (by incurring less losses than the market / benchmark), investors in equity mutual funds may lose some of the initial capital invested as the net asset value may fall below the value at the point of entry. Contrast this with the situation in money market mutual funds where the investment amount is almost always guaranteed.

Fixed Income or Bond Mutual Funds

These are mutual funds that invest primarily in individual bonds and other fixed income securities, and occasionally, preferred shares. They generally have higher expected returns and higher risk than money market mutual funds because their underlying assets have longer maturities (one year to 30 years). However, they have lower expected returns and lower risk than equity mutual funds.

Like equity mutual funds, the unit of measurement is the net asset value per share, which is determined as the sum of the value of each bond in the portfolio divided by the number of shares. Investors and participants in the mutual fund hold shares, which account for their pro-rata share or interest in the portfolio.

As mentioned earlier, one major advantage of mutual funds is the ease of entry / low minimum investment requirement. In the case of bond mutual funds, an investor can invest in a bond fund for as little as $15, which provides a stake in a diversified bond portfolio in which each individual bond may cost between $10,000 and $100,000.

Hybrid mutual funds

Hybrid mutual funds invest in both bonds and shares in a more balanced approach and share the characteristics of both the equity mutual funds and the bond mutual funds.

Hybrid mutual funds could also be customized to include various other characteristics. For example, certain fund managers have a hybrid mutual fund called a Guaranteed Investment Mutual Fund (GIF), which invests in high quality fixed income securities (75%) and equities (25%). The GIF limits the downside potential by offering a guarantee on the initial amount invested by participants. However, this reduced risk will likely result in lower expected returns.

Disadvantages of investing in mutual funds

Some of the disadvantages of mutual funds include:

1. Management cost: as mentioned earlier, the cost of managing the mutual fund in borne by you, the investor. This cost is often disclosed in the documentation (i.e., prospectus) of the mutual fund and should be considered when choosing which mutual fund to invest with. A high management fee does not always lead to superior performance by a mutual fund.
2. Tax inefficiency from capital gains exposure: in many jurisdictions (whenever the fund sells shares, which could happen quite frequently) capital gains are often distributed periodically, e.g., annually, and these gains are taxed when they are distributed to investors. Consider a scenario where you earn capital gains and have to pay capital gains tax (10% in many countries and 25% in Germany) every year. If you had invested in a vehicle that, instead of capital gains distribution, re-invests all capital gains (e.g., certain ETFs, you will have a better outcome. For illustration purpose, assuming you earn $100,000 gains, your tax (at 10%) would be $10,000. If that $10,000 had been reinvested instead of being paid out, you would have a right to 90% of whatever profits come from reinvesting that $10,000, indefinitely, until you sell or redeem your investment in the investment vehicle. Note that capital gains tax on equity securities in Nigeria is zero.
3. Trade execution: recall that the net asset value of a mutual fund is usually determined at the end of the trading day. This can result in inefficiencies. For example, a while ago, I bought some shares (thankfully, not in a mutual fund) which I sold at some point last week. By 3:30pm on the same day, there was an unusual swing in the market, around the time the markets opened in the US, and the price of most securities, including the security I had just sold, came crashing down. If I had held on to that security for an hour longer, I would have lost about 2% to 4% of the total amount I had invested in it. With mutual funds, you do not have the luxury of exiting your position during the day. If you give an instruction / place a trade to sell your holdings at 9:30am, your trade will not be executed until the end of that trading day, at closing prices.

I do not believe mutual funds to be the most optimal form of investments for individuals in all circumstances but they are a good starting point for people who do not know what to do with their money and have no other options, or in the case of money market mutual funds, for people looking to invest their contingency funds or savings for near-term purchases. However, you should familiarize yourself with other available investment alternatives and strategies such as ETFs, etc.