Mutual fund is a popular worldwide investment product with its net asset value (NAV) of $166.1 billion in 2017. In Hong Kong, there is a total of 2,215 SFC authorised funds, including unit trust and mutual funds. A mutual fund is an investment vehicle which allow investors to pool their money together for fund managers to form a diversified and lower risk portfolio by investing in stocks, bonds, derivatives and other assets.
Source: Securities and Futures Commission
History of mutual funds
The origin of investment fund is uncertain, but many traced it back to 1774, when during the European financial crisis, a Dutch businessman, Adriaan van Ketwich, created the first mutual fund called “Eendragt Maakt Magt” – which means “unity creates strength”. Van Ketwich believed that diversification by pooling a large sum of money together to invest in Europe and the colonies of United States is a good idea to increase the attractiveness of investment for small investor with minimum capital.
Mutual funds’ category and cost structure
In contrast to stocks purchases and sales, which simply a brokerage commissions fee is charged by a broker, mutual funds have various charging mechanisms for different fund classes, namely Class A, Class B and Class C share. These classes invest in the same portfolio, but commissions are charged differently as to serve investors with different purposes (see table 1). Apart from commission fees, mutual funds have three other major costs – subscription fees, management fees and transaction fees with their corresponding beneficiaries are brokers, fund houses and securities firms.
Differences between closed-end and opened-end fund
In addition to being classified as Class A, B and C shares based on different cost structures, mutual funds will also be divided into closed-end and open-end fund, according to their trading patterns and scale (see table 2). In general, a closed-end fund is created when a mutual fund raise money through an IPO and then trades on the exchange like a stock. Its price is determined by market supply and demand, could be at a discount or premium to NAV. Besides, many closed-end fund will have higher leverage ratio, so their risks and returns will be relatively higher, making them more suitable for aggressive investors.
Types of mutual funds
There are four major types of mutual funds, which are equity fund, balanced fund, fixed income fund and money market fund. They are classified according to the fund’s investment market. Equity fund has always been the largest type of mutual funds, mainly investing in stocks. The potential return of this type of fund is generally higher, and the corresponding volatility is also higher. Therefore, it is more suitable for aggressive investors. The share of such fund, based on the total fund sales, has been decreasing due to the financial tsunami in 2008. However, it gradually bounced back as financial market recovered. Balanced fund invests in both stocks and bonds, investment managers will adjust the proportion of investment vehicles in response to the market conditions. The risk of such fund is generally lower than equity fund as it enjoys the diversification benefit. Fixed income fund invests primarily in bonds or mortgages with a specified interest rate. It provides stable return, so it is more suitable for investors who need regular cash flow. Money market fund invests primarily in short-term and fixed-income securities. It has low volatility, but the corresponding return is also lower. Therefore, it is more suitable for conservative investors.
Source: Hong Kong Investment Funds Association Sales & Redemptions Survey
Differences between mutual funds and unit trust
Major fund centre and UCITS
Luxembourg is the second largest investment fund centre after the US, occupying 9.3% of the fund market worldwide in 2017 due to its low or zero tax rate. Luxembourg adopts “territorialism”, so the foreign income is not required to be taxed. This tax system has attracted many companies to invest and open subsidiaries in Luxembourg. In addition, Luxembourg is the main place for the registration, management and distribution of the Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS is a EU’s legislation to regulate investment funds of EU countries, so that the funds can be freely sold to other EU markets after obtaining the authorization of an EU member state. UCITS enjoys higher extent of liquidity, transparency, lower fees and a more diversified investment category than the general fund. Its 2020 asset management scale is expected to reach 1.2 trillion euros.
Advantages of mutual funds
There are four advantages of mutual funds. Firstly, a professional fund manager and management team are required for each mutual fund, which can reduce the time and effort of investors to manage their portfolio themselves. Secondly, mutual funds are a diversified portfolio that reduces the risk of investors by investing in different asset categories and in different securities within each category. Thirdly, mutual funds allow investors to invest in a diverse portfolio with less capital. Fourthly, mutual funds have greater liquidity than unit trust, which allow redemption takes place in a short period of time.
Considerations for selecting mutual funds
There are two primarily factors that investors should consider when selecting mutual funds, which are investment objectives and level of risk tolerance. Capital growth, fixed income and capital preservation are the three main investment objectives. After determining their own investment objectives and risk tolerance, investors can use quantitative measures to select funds. Alpha, Beta, and Sharpe ratio are the most common measures. Alpha is used to measure the excess return of funds, that is, the difference between fund returns and market returns. A positive alpha represents that the fund’s performance is better than the market, and it is suitable for investors whose investment purpose is to increase their capital. Beta is a measurement of systematic risk. Beta coefficient with less than or equal to 0.5 is a low-risk fund while a value greater than 2 is a high-risk fund. Funds with low beta coefficient is suggested to the person whose aims to preserve the value of capital. Sharpe ratio measures the risk-adjusted return on investment. It indicates how well an investment (equity/bond/portfolio) performs in comparison to the rate of return on a risk-free asset. A large Sharpe ratio representing the relative return to a unit of risk is greater, vice versa. So, in general, fund with a larger Sharpe ratio is considered superior relative to peers.
Instead of quantitative measures, investors can also measure funds by observing the size of funds, the experience of fund managers and funds’ past performance, including annual returns and standard deviations. Most importantly, investors should choose funds that meet with their investment purposes, rather than choosing funds that perform well but contradict to their objectives. In case investors are confused about the selection of funds, they may consult investment advisers and should understand all the details and risks involved.