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What
are Mutual Funds?
What do Mutual Funds offer
the investor?
What are the different types
of mutual funds?
Fund Classifications
Open-end vs. Closed-end
Factors to consider when
selecting a mutual fund
What are Unit Trusts?
Are unit trusts risky?
What are tracker funds?
What are the costs associated
with unit trusts?
Are investment trusts the
same as unit trusts?
Unit Trust Sectors
Specialist Funds
What are investment Trusts?
What are the costs associated
with investment trusts?
Can an investment trust
be in the form of an ISA?
What are mutual
funds?
Mutual funds are financial intermediaries that is a type of
company set up to receive your money, and then having received
it, to make investments with the money. A buyer of a mutual
fund is a shareholder/owner of that fund with voting rights
in proportion to his/her ownership of the fund.
Every mutual fund issues a prospectus, which describes the fund's
investment policies and objectives, risks, costs historical
performance data, and various other legalities. The prospectus
will mainly allow the investor to discover the investment style
of the fund.
Mutual Funds offer the investor:
Diversification: By buying a mutual fund an investor has instant
holdings in several different companies, offering a level of
stability to one’s investments.
Liquidity: Similar to individual stocks,
a mutual fund investment can easily be converted into cash
upon the investor’s request.
It should be noted though that
Mutual Funds do not offer the investor control of picking
his/her individual stocks. There is also sometimes the risk
of over diversification/dilution and the costs associated
with mutual funds for the professional services provided.
Overall though mutual funds automatically offer the investors
diversification, even with a small amount of money, an investor
can own shares of hundreds of stocks or bonds because mutual
funds pool money from lots of small investors and invest in
a large portfolio with many securities. It should be noted
though like with equity stocks mutual funds are risky. For
an investor to be successful in mutual fund investing, he/she
must be patient and use the fund as a long-term investment
vehicle. There are different types of funds and various fund
classifications, which will be discussed below.
Types of Mutual
Funds
|
Fund Type
|
Typical Investment
|
Risk Level
|
Compound Annual
Return (%) to Jan 1, 1995
|
|
1 yr.
|
3 yr.
|
5 yr.
|
|
Aggressive Growth
|
High risk stocks
of up and coming new firms
|
Very High
|
-1.2
|
8.7
|
11.7
|
|
Capital Growth
|
Midsize or large
company stocks with solid prospects for appreciation
|
High
|
-1.8
|
6.3
|
9.1
|
|
Growth and Income
|
Stocks of established
dividend paying firms
|
High
|
-0.9
|
6.3
|
8.0
|
|
Equity total
return
|
High dividend
stocks and bonds, emphasising growth
|
High
|
-2.7
|
5.8
|
7.4
|
|
Income total
return
|
High dividend
stocks and bonds, emphasising yield
|
Medium
|
-4.2
|
7.0
|
8.6
|
|
Specialty
|
Stocks for individual
industries and precious metals firms
|
Medium to Very
High
|
-4.0
|
9.0
|
7.6
|
|
International
|
Fully or largely
invested in foreign stocks
|
High
|
-2.5
|
8.6
|
5.6
|
|
Foreign Regional
|
Stocks in a
single region or country
|
Very High
|
-6.7
|
8.2
|
2.8
|
Fund Classifications
Bond Funds: Bond mutual funds are where the pooled amounts
of money raised by the fund are mainly invested in bonds. Bonds
basically are IOUs issued by companies or governments. A purchaser
of a bond (the Fund) is lending money to the issuer, and will
usually collect some regular interest payments until the money
is returned. The amount of interest paid (the coupon) is usually
fixed at a set percentage of the amount invested, thus, bonds
are called "fixed-income" investments.
General Equity (Stock) Funds: Here we have the fund basically
investing in various stocks of corporations with the goal of
seeing the value of the companies’ increase over time.
Stocks are categorized by their capitalization/market cap, which
come in three basic sizes: small, medium, and large. Many mutual
funds focus primarily in one of these sizes and are thus classified
as large-cap, mid-cap, or small-cap funds. The type of stock
that is bought as seen above also categorizes mutual funds.
Mutual fund types are generally "growth," "value,"
or a combination of the two, called "blend."
Balanced Funds: Balanced funds are a combination of stocks
and bonds. A typical balanced fund may contain 50-65% stocks,
and hold the rest of the shareholder's money in bonds and cash.
It is important for an investor to know the distribution of
stocks to bonds in a specific balanced fund to be able to understand
the risks and rewards associated with that fund.
Global/International Funds: Global and international
funds are funds, which invest in companies outside the US. These
funds are more volatile than domestic funds. International funds
invest only in foreign companies whilst global funds may include
some US based companies.
Sector Funds: Sector funds focus on one particular sector of
the economy such as technology, banking, computers, the Internet,
etc. Sector funds are sometimes extremely volatile because the
broad market will find certain sectors very attractive and very
unattractive often in rapid succession.
Index Funds: Index mutual funds own a full participation
in some portion of the stock market. That is an index fund matches
the shareholdings of a target index, such as the Standard &
Poor's 500. Index funds differ from actively managed mutual
funds in that they do not involve any stock picking, they simply
seek to replicate the returns of the specific index.
Open-end vs.
Closed-end
Mutual funds can also be categorized into two other distinct
types that of open-end and closed-end funds. In an open-end
fund investors can continually buy and redeem shares. These
funds are required to establish a daily price for shares the
net asset value, or NAV. The NAV is calculated by dividing the
total asset value of a mutual fund by the number of shares outstanding.
Shares of mutual funds must be bought or sold at the current
daily NAV both by investors and Mutual fund companies.
A closed-end fund on the other hand issues a fixed number of
shares to raise capital, similar to selling stock in initial
public offerings (IPOs). After the initial offering, the closed-end
funds shares trade on an Exchange or over the counter. Hence
supply and demand determine the price of the closed-end fund.
This is similar to an equity stock in that when demand is high,
investors are willing to pay a higher price for the fund and
when demand is low, the share may sell at a discount. Price
volatility on a closed-end fund can be very high hence timing
is more important than for purchasing and open-end fund.
Factors to Consider
when selecting a Mutual Fund
Similarly to stock an investor needs to gather as much information
about a mutual fund before deciding to purchase it. The fund's
prospectus, which describes its goals, stocks, prior performance,
manager, fees, and other information, is a very important tool.
An investor should also review the annual or semi-annual shareholder
report, which lists the stocks the fund currently, holds. A
good fund should have the following characteristics:
Consistency: Ensure that the fund has consistently made
money in the past, you want to be sure it will perform well
in the future.
Bearable risk: Do not purchase a mutual fund, which may
seem too risky for you. Hence review the fund's worst year in
the past 10 years. Are you willing to lose that much in a bad
year?
Low Expenses: Review the fees associated with the funds
that interest you. The average equity fund has an expense ratio
of 1.3% and the average may range from 1.2% to 1.9%, depending
on the type of fund.
Manageable
asset size: Be cautious of funds, which have grown rapidly,
funds, which may have doubled, in the past year. Fast-growing
funds can overload the manager with extra cash, causing him
to make hurried investment decisions.
Tax efficiency: Investors must pay taxes on profits
from mutual funds hence seek for high tax efficiency.
Points to consider:
1. No sales charges (front loads, contingent deferred
sales loads, level loads)
2. A low expense ratio (below 1.00%)
3. Low turnover, no higher than 50% a year, and preferably
closer to 20%
4. Full investment policy. Cash reserves of nearly
0%.
An investor should ensure that he/she is not paying any sales
charges when purchasing a mutual fund. These charges can come
in different forms such as loads or commissions. There may
be a charge for buying into the fund (a front-end load) or
selling the fund (back-end load, deferred sales charge, or
redemption fee). Certain funds have back-end loads that are
reduced the longer the fund is held.
Expense ratios represent the annual fees charged by all funds
inclusive of the management fee, the administrative costs,
distribution fees, and other operating expenses. As investor
you should ensure you are receiving what you are paying for.
These fees should be as low as possible. Index funds typically
charge about 0.20% of the assets, and actively managed funds
currently average about 1.5% per year. These fees are rising
every year.
Turnover measures how long stocks are held by a fund. The
longer a stock is held the lower trading will be taking place
hence the lower turnover will be. Hence the lower turnover,
the lower the transaction costs incurred by the fund. Funds
that have a turnover of 100% are essentially buying a completely
new set of company stocks every year. Turnover should correctly
be substantially lower than the mutual fund average of about
80%. Index funds may have turnover as low as 5%.
Consistency of the fund's returns should be highly considered.
An investor should not only be looking for a fund with good
returns but returns which are consistent year after year hence
you will avoid surprises.
Unit Trusts
Unit trusts similarly to mutual funds invest in an array of
diverse shares so the investor does not have to. They are an
ideal investment choice for new and experienced investors alike.
Investors can hold unit trusts in a tax-free wrapper through
a Personal Equity Plan, or its new replacement, the Individual
Savings Account that gives one’s investment an extra boost
to avoid tax.
Long term, investment in the stock market through unit trusts
allows an investor to obtain a spread of risk and expert investment
management. Money invested in the stock market through unit
trusts does better than money left on deposit at the bank or
building society. This is due to the fact that shares in well-run
companies tend to increase their dividends by greater than the
inflation rate and that increase tends to push share prices
up in the medium term. Money in the building society may earn
interest but interest rates take as much time going down as
they take going up.
There are over 1,500 different types of unit trusts. Some invest
in UK shares that aim to pay out an income through high dividends
whilst others buy shares in firms which pay out low dividends
but know how to reinvest profits to produce more money in the
longer term. Some unit trusts invest in the Far East, Continental
Europe, or North America. Some even buy shares in companies
quoted on the small and high risk stock markets of the Third
World.
With most trusts, an investor can invest around £50 a
month, although some trusts will accept as little as £25.
Unit trusts similarly to stocks quote two prices: offer, the
price you buy from the managers, and bid, the (lower) prices
at which you can sell your units back. Although, some unit trusts
are changing their structure to become so-called Open Ended
Investment Companies (OEICs) which quote just one price and
as such, are simpler to understand
Investors pay tax, deducted at source, on their income, plus
capital gains tax when the unit trust is sold. However investors
can shelter their investments in an Individual Savings Account,
this can be avoided completely.
Are unit trusts
risky?
In the short term they can be because share prices move up and
down but long-term investments with money that will not be needed
for four or five years greatly limits that risk. Unit trusts
are though less risky than direct equity.
How can that be?
Due to the fact that unit trusts pool the savings of thousands
of investors and then buy into shares of many different companies
each single investors risk is diversified and not dependant
on one particular company. Professional full-time qualified
investment managers make key investment decisions.
If unit trusts are risky why buy them at all?
It is a rule of investment that greater risk equals greater
reward. Hence if an investor invests his/her money in Mexico
their money could be doubled in a year, or half can be lost
in no time.
What are tracker
funds?
Tracker funds are similar to index funds in that they simply
track a stock market index rather than try to buy shares in
companies that will do better still. Tracker funds are a new
type of investment product, which try to surpass the perceived
drawback of traditional funds. These tried to buy shares in
companies, which they hoped would do so well that they would
beat the relevant index. Trackers do something very different,
they attempt to track the performance of the index itself, rather
than trying to beat it. The theory behind this being that no
traditional manager manages to do better than the index for
very long, and if that is so, it makes more sense to literally
track the index.
How is this accomplished?
This is achieved either by buying shares in all the companies
that make up the index, or by using complex financial instruments
to track what the index actually does.
Does this have any advantages?
Yes, since tracker firms do not require expensive teams of experts
who need to follow what individual companies are doing, they
are cheap to run. They are cheaper still because they do not
have the costs involved in buying and selling different shares
on a regular basis and as a result, the costs of investing are
lower for the investor.
What are the
costs associated with unit trusts?
The fund management group selling the trusts has to pay experts,
handle the admin, and make a profit itself. This up front load
fee can easily be up to 5% and then 1-1.5% of the investment
a year. This up-front charge is one reason why investors must
see this sort of investment as being for the long term, on the
first day of your investment your money has to grow by 5% just
to put you back where you were. Here at thefundsite.com our
aim is to obtain for you the lowest possible front load fee
so that most of your investment is invested.
Are investment trusts the same as unit
trusts?
No, although both structures work in similar ways, investment
trusts are quoted companies in their own right. Hence the share
price of the investment trust can move independently of the
assets owned by the trust. Therefore there is an extra risk
factor to be taken into account. Investment trusts have generally
done better for their investors than unit trusts, but are slightly
riskier. This is what discount means, the value of an investment
trust is less than the value of all the shares it owns. This
discount moves up and down in line with demand for the trust.
Unit Trust
Sectors
Income funds 1 - funds aiming at immediate income UK
Gilt - at least 80% of their assets must be invested in UK Government
securities (Gilts).
UK General Bond - at least 80% of their assets must be
invested in corporate or public fixed interest securities.
Global Bond - at least 80% of their assets must be invested
in fixed interest securities. Funds in this sector usually contain
a spread of government and other fixed interest securities from
all over the world. They are managed to take advantage of varying
interest and currency rates between the different economies.
UK Equity & Bond Income - at least 80% of their assets
must be invested in the UK, with between 20% and 80% in UK fixed
interest securities and between 20% and 80% in UK shares. These
funds aim for a yield, which is more than 120% of the FTSE All-Share
Index. The fixed interest element allows the fund to provide
a relatively good level of income and offer more security of
capital than an equity fund.
Managed Income - contains at least three asset classes,
but no more than 60% can be invested in shares. The fund aims
to have a yield of at least 120% of the FT All Share gross yield
before charges and it can include convertibles.
Income funds 2 – the fund aims at a growing income
UK Equity Income - at least 80% of their assets must be invested
in UK shares and which aim to have a yield in excess of 110%
of the FTSE All Share Index. Fund Managers of such funds choose
UK shares in a broad range of industries with yields that are
above average compared with UK shares in general. Companies,
which are expected to be able to pay steady or increasing dividends
in the future, are chosen. Capital growth is not a priority
here, although in the past they have tended to produce good
levels of capital growth as well.
Global Equity Income - at least 80% of their assets must
be invested in shares and which aim to achieve a yield which
is more than 110% of the FTSE World Index. This sector includes
funds which specialise in higher yielding, international shares
to cater for investors seeking an income.
Growth funds 1 - funds with a capital protection objective
Money Market - at least 95% of their assets must be invested
in cash and near cash, for example bank deposits and very short
term fixed interest securities. This in a way offer small investors
to obtain 'wholesale' rates of interest at the same time retaining
easy access to their money.
Guaranteed/Protected (other than Money Market/Cash funds)
– the fund’s aim is to provide a return of a set amount
of capital back to the investor, with the potential for some
growth.
Growth funds 2 - funds with a capital growth/total return
objective UK All Companies. - at least 80% of their assets must
be invested in UK shares which have the primary objectives of
achieving capital growth. The investment style here may vary
according to the fund manager’s.
UK Smaller Companies - at least 80% of their assets must
be invested in the shares of UK companies which form part of
the Hoare Govett Smaller Companies Index or which have an equivalent
or lower market capitalisation. These funds are generally considered
of high risk.
Japan - at least 80% of their assets must be invested
in Japanese securities.
Far East including Japan - at least 80% of their assets
must be invested in Far Eastern securities including Japanese
securities. But less than 80% of this must be invested in Japan.
Far East excluding Japan - at least 80% of their assets
must be invested in Far Eastern securities, excluding Japanese
securities. This includes funds investing generally throughout
the Pacific Basin, which consists of Australian or New Zealand
securities.
North America - at least 80% of their assets must be
invested in North American securities. Most funds under this
category invest in a broad range of US companies, including
Canadian companies.
Europe including UK - at least 80% of their assets must
be invested in European securities. This may include UK securities,
but they cannot exceed 80% of the fund's assets.
Europe excluding UK - at least 80% of their assets must
be invested in European securities but cannot UK securities.
Cautious Managed - invests in at least three asset classes,
but the maximum equity exposure is restricted to 60% of the
fund. Hence assets must be at least 50% denominated in Sterling/Euro
and shares must include convertibles.
Balanced Managed - contains at least three asset classes
and the shares are limited to 85% of the fund. At least 10%
are restricted to be held in non-UK shares. Assets must be at
least 50% in Sterling/ Euro and shares are deemed to include
convertibles.
Active Managed - offers investment in a range of assets
and up to 100% of the fund can be invested in shares. Also,
at least 10% must be held in non-UK shares. There is no minimum
Sterling/Euro balance and shares can include convertibles if
desired. At any one specific time the asset allocation of these
funds may hold a high proportion of non-equity assets. It must
be noted though that the funds would remain in this sector since
it is the Manager's stated intention to retain the right to
invest up to 100% in shares.
Global Growth - at least 80% of their assets must be
invested in shares which have a primary objective of achieving
growth of capital.
Global Emerging Markets - 80% or more of their assets
must be invested directly or indirectly in the emerging markets,
which is defined by the World Bank. Although indirect investments
such as China shares listed in Hong Kong, should not exceed
50% of the portfolio. This category typically invests in rapidly
developing economies and is higher risk investment than those
in more established markets.
Property - at least 80% of their assets must be invested
in property securities. Although there is little actual investment
directly held in property.
UK Equity & Bond - at least 80% of their assets must
be invested in the UK, with between 20% and 80% in UK fixed
interest securities and between 20% and 80% in UK shares. The
aim of these funds is to have a yield of up to 120% of the FTSE
All-Share Index. The fixed interest element offers a relatively
good level of income and more security of capital than an equity
fund. This type of balanced funds usually aim to provide a combination
of income and growth. Some focus on providing high levels of
income with some opportunity for growth.
Global Equity & Bond - between 20% and 80% must be
invested in fixed interest securities and between 20% and 80%
in shares. The objectives here are similar to UK Equity &
Bond funds except that these can invest in all the major markets
of the world.
Specialist
funds
Specialist Regional Funds – Here six sectors are
subdivided by the geographical location of the underlying investments.
Therefore these sectors incorporate funds which do not fit comfortably
into other sectors. This can include funds concentrating on
a single country (e.g. Greece), a single theme (e.g. ethical)
or a single sector (e.g. technology). UK Specialist, North American
Specialist, European Specialist, Japanese Specialist, Far East
Specialist, Global Specialist are examples of this.
Pension Funds - only available for use in a personal
pension plan or FSAVC scheme. They offer arrangements for unit
trust personal pension schemes which require providers to set
up separate funds under an overall tax-sheltered umbrella. These
funds then invest in the group’s equivalent mainstream
funds. Pension funds should not be confused with 'exempt' pension
funds, which are operated mainly for institutions.
Index Bear Funds - designed to track the performance
of an index by using derivatives and are only suitable for investors
prepared to accept a high level of risk.
Investment
trusts
An investment trust is a company, which is quoted on the stock
exchange whose business is holding shares in other companies.
If shares in those companies do well, then the trust in turn
does well and it’s share price increases and vice versa.
The main point to note here is that of diversification. One
company listed on the exchange may go bankrupt but hundreds
will not do so at one time. There are currently over 300 investment
trusts with combined assets of around £60 billion.
To a large extent investment trusts and unit trusts aim to do
the same things, but there are several key differences. These
are:
| • |
Investment trusts are quoted
companies and are required by company law to publish audited
full-year results, an annual report and to hold an annual
general meeting. |
| • |
The board is accountable
to shareholders. |
| • |
The price of an investment
trust share does not just depend on the value of the shares
in other companies that it holds but also depends on the
demand for the trust shares themselves. Most investment
trusts are worth less than the value of they shares they
own. This is known as the discount and currently is around
the 15% mark on average. |
| • |
Investment trusts can invest
in the shares of unquoted companies, and they can also
borrow money to buy shares. This is an advantage in rising
markets, as the gain on the share prices will be more
than the interest on the money borrowed, but can backfire
in falling markets. |
How does this affect investors?
It makes investment trust riskier than unit trusts for investors
but in turn more rewarding as well. If an investment trust is
bought at a 15% discount, £1 worth of assets is bought
for 85p. If the demand for this trust’s shares should rise,
then this discount could close, giving the investor an extra
boost. But this can also work the other way hence widening the
gap.
What are the
costs involved with investment trusts?
Investment trusts are very cheap to purchase. They do not pay
front load fees to middlemen hence 0% of the investment is lost
to up front fees.
How can money be invested?
Investors can invest as a lump sum or on a monthly basis. Monthly
schemes are generally called savings schemes, or sometimes share
plans or investment plans. They are mostly offered by investment
trust management companies. Minimum contributions are usually
in the region of £30-£50 a month.
Can an investment
trust be in the form of an ISA?
Yes it can, via a financial institution offering investment
trusts ISAs. A manager approved by the Inland Revenue will administer
the account. The account manager will be responsible for the
administration of the ISA, including registering it with the
Inland Revenue, and for reclaiming the dividend tax credit.
What types of investment trusts exist?
There are several types similar to those of unit trusts. Trusts
investing in the UK, others in the Far East, in smaller companies,
or in Europe. The most popular investment trusts are the so-called
international general trusts. These are very large trusts, which
invest across all the world’s major stock markets.
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