A fund is a collective investment scheme that pools the money of many i and invests it in stocks, bonds, currencies, commodities or other securities to pursue a specific financial objective. Professional money managers select the particular securities that they believe will help the fund achieve the shareholders' "mutual" goal.
In Hong Kong, the most common types of funds are open-ended mutual funds and unit trusts. Both are essentially the same from an investment point of view. Legally, a mutual fund is set up as an investment company and investors are shareholders who own the shares. Assets are kept by the custodian. A unit trust is set up as a trust with a trust deed; the investors are unitholders (beneficiaries) who own the units. The trustee safe keeps the assets. The independent trustee or custodian must be a financially sound financial institution of good credit standing, and is appointed to hold the Fund's assets in trust. While these assets will be registered in the name of the trustee or custodian, they do not form part of those trustee or custodian's own assets. The trustee or custodian has a legal duty to ensure that the Fund operates in a manner as declared in its constitutive documents.
There are nearly 2,000 mutual funds authorized by Hong Kong SFC. Funds can be broadly categorized in the following groups: money market funds; bond funds; balanced funds (which own both stocks and bonds), stock funds and derivative funds. Within these broad categories, there are specific types of funds. Stock funds, for example, range from the more conservative "growth and income" funds to the more aggressive small company and single country funds.
Mutual fund is a trust or an investment company that pools the savings of a number of investors who share a common financial goal. The money collected is invested in capital market instruments such as stocks, bonds, and other securities. The income earned through these investments is shared by its unit holders in proportion to the number of units owned by them. Mutual fund units are bought and sold on the basis of a fund's net asset value (NAV). Unlike a stock price, which changes constantly according to the forces of supply and demand, NAV is determined by the daily closing value of the underlying securities in a fund's portfolio on each unit.
In addition, the Fund's assets are segregated from the other assets of the fund company, and the fund's investment activities are monitored by various independent entities. As for the general supervision, funds are regulated by the Hong Kong SFC. Thus a mutual fund offers a convenience way for individuals to invest in a diversified, professionally managed basket of securities at a relatively low cost.
A mutual fund comprises five separate entities, namely Investment Advisor, Administrator, Transfer Agent, Independent Public Accountant and Custodian.
A fund’s investment adviser is often the fund’s initial sponsor and its initial shareholder through the “seed money” it invests to create the fund. Investment adviser invests the fund’s assets in accordance with the fund’s investment objectives and policies as stated in the registration statement it files with the SEC.
A fund’s administrator oversees other companies that provide services to the fund, as well as ensuring that the fund’s operations comply with applicable regulations. Fund administrators typically provide general accounting services for the fund and help maintain internal controls. Often, they also assume responsibility for preparing and filing SEC, tax, shareholder, and other reports.
Mutual funds are required by law to protect their portfolio securities by placing them with a custodian. Mutual funds mainly use trust companies, banks or similar financial institutions for holding and safeguarding the securities owned within the funds. Often provisions are in place requiring the bank to segregate mutual fund portfolio securities from other bank assets. A custodian may also act as the fund's transfer agent, maintaining records of shareholder transactions and balances.
The most prevalent and well-known type of mutual fund operates on an open-ended basis. This means that it continually issues (sells) shares on demand to new investors and existing shareholders who are buying. It redeems (buys back) shares from shareholders who are selling. According to SFC’s report in March 2013, there are nearly 2000 authorized mutual funds in Hong Kong and there are over 5500 choices of mutual funds if we account different share classes offered. With such a large universe of fund choices, it is important to understand the different types of mutual funds with different risk and reward profile.
In general, there are three major types of mutual funds representing the major asset classes: money market funds, equity funds, and bond funds. Within the three major asset categories, mutual funds invest in many different sub-asset classes along with different investment styles.
1. Money Funds
Money market funds consist of short-term debt instruments, mostly Treasury bills. It is often used for parking purpose. A typical return expectation is similar to what you would earn in a regular checking/savings account. However, there is no guarantee against loss of principal.
2. Bond Funds
Bond funds aim to provide current income on a regular basis and primarily invest in government and corporate debts. While the underlying holdings may appreciate in value, the primary objective of these funds is a steady cash flow stream. Bond funds are likely to pay higher income than time deposit and money market investments, but bond funds aren't without risk. Because there are many different types of bonds, performance of bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is generally much more risky than a fund that invests in government securities.
3. Equity Funds
Equity funds invest in stock securities and represent the largest category of mutual funds. Generally, the investment objective of this class of funds is long-term capital growth. There are, however, many different types of equity funds differentiate by their geographical, market capitalization, and style focuses. One of the ways to understand the universe of equity funds is to use a style box, an example of which is below.
The style box was created by Morningstar for investors to determine the risk-return profiles of their equity mutual funds. A relatively low-risk stock investor would confine to the large company size combined with selections in the value and/or blend in the investment style categories. In contrast, a risk seeker might prefer small company size with growth style aiming for a high-risk high-return opportunity.
4. Balanced Funds
A combination of the three major asset classes makes up the forth category of mutual funds, namely the balanced fund. Its objective is to provide a balanced mixture of safety, income and capital appreciation. The weighting might also be restricted to a specified maximum or minimum for each asset class.
A similar type of fund is known as an asset allocation fund with objective similar to those of a balanced fund, but these kinds of funds typically do not have to hold a specified percentage of any asset class. The fund manager has the freedom to switch the ratio of asset classes as the economy moves through the business cycle.
Some types of mutual funds forgo broad diversification to concentrate on a certain segment of the economy. Hence, they don't necessarily belong to the categories we have described so far, and we name them the specialty funds.
1. Sector Funds
Sector funds target a specific sectors or industry such as financial, technology, healthcare, etc. Sector funds have concentrating investments and are more volatile than funds invest in broad market/ economy.
2. Regional Funds
Regional funds focus on a specific geographical area or a single country, such as Asia, Europe or India. These funds make it easier for investors to access securities in foreign countries, which is otherwise difficult and expensive. Regional funds also present a high concentration risk as well as political and economic risks specified to the respective regions.
3. Socially-Responsible Funds
Socially-responsible funds (or ethical funds) invest only in companies that meet the criteria of certain social and ethical beliefs. Most socially responsible funds don't invest in industries such as tobacco, alcoholic beverages, weapons or nuclear power. Some mutual funds adopt a stricter ESG (environmental, social and governance) guideline to determine the future financial performance of companies. The idea is to earn profit with a healthy conscience. These funds subject to a high degree of government regulation risk.
4. Life-cycle Funds
Life-cycle funds will automatically change their asset allocations to reduce risk over time. As an investor ages, life-cycle funds reduce their allocations in stocks and increase their allocations in bonds, in recognition that a reduced risk tolerance level for unit holders approaching retirement. These funds also called the target date fund. However, there is no guarantee that an investor’s retirement goal will be met.
5. Hedge Funds
Hedge funds generally assume more risk than traditional mutual funds and employ derivative instruments in their investment strategies to maximize absolute returns. Hedge funds are typically not as liquid as traditional funds, meaning it could be more difficult to redeem units.
There are different methods for computing rates of returns and all yield different results. Common types of investment performances display on fund factsheets include Calendar Year Return, Cumulative Return, Annualized Return and Internal Rate of Return (IRR). In addition to understanding the differences between the calculation methods, investors must learn what kind of calculation method can provide the most useful and appropriate return information, with such to compare with the peer group or the appropriate benchmark index.
1. Calendar Year Return is a kind of holding-period return, namely the one-year period return that begins on January 1 and ends on December 31. For example, a fund trading at $10 on Dec 31, 2011 and rise to $12 on Dec 31, 2012 is said to have a calendar year return of 20%. The holding-period-return formula is as follows:
2. Cumulative Return has the same calculation method as calendar year return, with the only difference in the length of holding period. Fund factsheets generally display various cumulative returns including 1, 3, 5, and 10 years as well as since launch. If a fund is trading at $10 on Dec 31, 2007 and at $13 on Dec 31, 2012, the 5-year cumulative return for this fund is 30%.
3. Annualized Return takes into consideration the compounding effect of an investment each year and provides a geometric average return rather than an arithmetic average. Annualized Return = (Ending Price/ Total Invested Amount) day/ 365-1。 As in the example above where the cumulative return is 30%, the 5-year annualized return should be 5.4%. In other words, If you invest HK$100 in the first year, your investment should value at HK$105.4 ($100x(1+5.4%)) at the end of first year, and it will grow to HK$111.09 ($105.4x(1+5.4%)) at the end of second year, and so on it will value at HK$117, HK$123.4 and HK$130 at the remaining 3 years respectively.
4. Internal Rate of Return (IRR) is the discount rate that makes the net present value of all cash flows from a particular investment equal to zero or in other words the rate at which an investment breaks even. The capital injection and redemption will highly impact the value of IRR. The calculation of IRR is more complicated, but it best reflects the return on regular savings investment, such as monthly savings.
Internal Rate of Return (IRR) Formula:
As an illustration, suppose we invest $1,000 monthly into a mutual fund, the fund's initial unit price is $10, so you purchased 100 units (Table I). A month later, the fund rose to $10.1 and total number of units bought is 199, while your asset rose to $2,010. In early April, your total assets rose to $3,059.6. In simple calculation, the holding period return is 1.99%, but in fact the quarterly IRR rate of return should be 2.99%.
Due to the fact that more money is invested at a later stage, and the holding periods of the later investments are shorter, as such although the nominal rate of return looks the same, the IRR will be significantly higher than the holding-period return. Thus, IRR gives a more accurate picture of the long-term investment performance for regular savings investment, reflecting the effect of dollar cost averaging.
According to HKIFA’s findings of a retail investor survey in the first quarter of 2013, the population of retail investors continues to grow in Hong Kong, from 34% in 2011 to 37% in 2012, and further up to 39% in 2013. Hong Kong stocks continue to be the most popular investment product followed by mutual funds. However, Hong Kong stocks witness a drop in penetration while investment in mutual funds (excluding MPF) has been on an upward trend in the past few years with record high gross and net sales registered in 2012, at US$54.9 billion and US$14 billion respectively. The growing popularity of funds can be traced to six advantages that they offer to individual investors:
When you buy an individual stock or bond, you risk losing money on your investment if the issuer encounters financial difficulties. While you cannot eliminate this risk, the best way to reduce it is to buy a diverse mix of securities whose potential ups and downs counterbalance each other, reducing the overall risk to your principal. Achieving effective diversification on your own can require more money and effort than you may be able to afford.
You can easily expand your purchasing power through fund investment. Your fund may buy hundreds of different stocks, bonds, and money market instruments, spreading your money over many securities, companies, and industries - and adding stability to your investment program.
2. Professional Management
When you invest in a fund, you are hiring full-time professional money managers to buy and sell the securities in your fund. These managers are experienced in interpreting the complexities of the financial markets, and are backed by talented analysts who conduct extensive research on individual companies as well as entire industries. Professional money management has long been available to large companies and wealthy individuals. Funds make this financial expertise accessible to everyone at a reasonable cost.
Unlike assets that can't be sold early without penalty (such as CDs) or are time-consuming to sell (such as real estate), you can usually sell your fund holdings quickly and easily on any business day, at their then-current price. Of course, share prices fluctuate, so you may collect more or less than your original purchase price when you sell your fund.
Mutual Funds simplify your investment life. At most fund companies, you can make your purchase and redemption by telephone and mail, followed by completed forms. With advances in technology, online investment platform, where you can buy and sell mutual fund electronically, is the new trend and makes your life easier.
5. Low Cost
Even if an individual has the knowledge and time necessary to manage a profitable portfolio, the transaction costs of buying and selling securities might far exceed the costs of investing in a mutual fund. Because of their size, mutual funds are able to negotiate brokerage fees and related costs down to the bare minimum.
6. Ease of Recordkeeping
Fund companies and investment advisors can keep track of all paperwork necessary for taxes and investment purposes on your behalf. They will mail or reinvest your dividend payments and provide accurate, comprehensive year-end statements. Most funds also provide telephone customer service hot-lines to answer questions about your investment.
A unit trust or mutual fund has certain features that are not desired by certain investors. Below are some factors which may be considered disadvantages:
All mutual funds charge expenses. These include initial charge (front-end load), annual management fee, trustee/custodian fee, administration fee and sometimes performance fee. In addition, expenses such as marketing or brokerage fees, fund expenses are generally passed back to the investors.
2. No Control on Investment
Investment decisions are made by the investment manager. Investors exercise no control over what securities the fund buys or sells.
The structure of a fund separates ownership from management. The investment manager cannot access the fund’s assets, securities or cash. These assets are under the custody of the trustee or custodian. There is basically no default risk for Hong Kong SFC authorized funds. With regard to default risk, funds are even safer than bank deposits.
Mutual funds are, however, subject to market risks, including the possible loss of principal. The degree of risk will vary from fund to fund reflecting the investment objectives and management strategy. Of course, greater risk may be accompanied by the potential of greater profit. The spectrum of investment risk spans from bank deposits, money market funds, international bond funds, international equity funds, high yield bond funds, regional equity funds, single country equity funds, to derivative funds and hedge funds.
The price of the fund is determined by the net asset value (NAV), which is the value of the fund's underlying securities. Unlike stock price, which moves during exchange opening period, a fund's NAV is calculated at the end of the trading day. Any buy or sell order received on that day is traded based on the net asset value calculated at the end of the day, plus front-end load or less exit charge. Most funds calculate NAV daily, a few funds are on weekly or monthly valuation.
For dealing in most Hong Kong authorized funds, the price is calculated on a forward basis. This means that the fund price is not determined when you place your order, but will be based on the market closing price on that same day. Although it may seem inconvenient not to know the dealing price until after your order has been executed, forward-pricing ensures that the price you pay most accurately reflects the value of the Fund on the day the order was placed.
Though it is rare nowadays, some funds still deal on a historic or "known" price, usually based on the previous day's closing price. The problem with historical pricing is that existing investors may be disadvantaged when the market experiences large fluctuation.
There are at least three ways in which you can make money from mutual fund investing. The first two are based on your fund manager's decision, and the last one is based on your own.
1. Income Dividends
If the securities in your fund's portfolio earn dividend or interest payments, this money is distributed to the fund's investors or reinvested. Income dividends are distributed on a set schedule - usually semi-annually or annually. Investors whose goal is to meet current expenses generally arrange to receive this income in cash payments. Those aiming to meet a long-term goal, however, generally arrange to reinvest this income in order to maximize their potential results.
2. Capital Gains Distributions
When the fund manager sells securities at a profit, called a capital gain, the profit may be distributed to the fund's investors or reinvested into other securities.
3. Profit from Selling Shares
When you redeem a fund's units or shares, you may realize a profit if your redemption price is higher than your original purchase cost. (Share prices fluctuate, of course, and you may realize a loss if you sell the units/shares at a price lower than your cost.)
A fund's investment performance is measured by its total return. A fund's total return is the increase in the total value of an investment over a specific time period, taking into account the reinvestment of income dividends and capital gains, as well as any share price gain or decline during the period.
There are two broad classes of mutual fund costs: loads charged when you buy or sell shares, and expenses incurred in the fund's operation.
A front-end load or initial charge is assessed when an investor initially purchases a fund. The charge ranges from 2% to 7%, depending on type of funds. Money market funds usually do not charge front end. Bond funds mostly charge 3-5% whilst equity funds commonly charge 5-6%. Warrant and derivative funds may charge up to 7%. The initial charge is usually calculated based on the net asset value (NAV) of the fund.
Alternatively, a fund may charge a back-end load, also called exit charge or redemption charge. A back-end load is charged when you sell the fund. The charge ranges from 1% to 5%. In most cases, the charge is on a sliding scale and becomes nil after a long enough (usually 5 years) holding period.
A fund that does not charge front-end or back-end is called a no-load fund. In Hong Kong, there is no true no-load fund yet. The so called no-load funds are back-loaded. Some funds may also set up a lock-up period, meaning that investors are only allowed to redeem fund's unit after a particular period. Investors are not allowed to redeem or sell shares during lock up period.
3. Operating Expenses
Operating expenses are implicit charges which are calculated and deducted from the fund on a regular basis. The NAV already takes into account such charges and the investor does not have to pay out-of-pocket.
A fund charges annual management fee to pay the investment manager. Management fee is the largest component of operating expenses. The management fee is stated as a fixed percentage of the fund's total asset value. Money market funds charge a fraction of one percent per year. Bond funds are usually charged 0.5%-1.25%, equity funds 1.0%-2.0% and derivative funds 1.5%-2.5%. In addition, some funds may charge performance fee. These performance-based funds are usually of high risk category and target at sophisticated investors. The most common form of performance fee is a charge on high-water mark principle. It usually requires the fund to pay a certain percentage of difference between the fund's NAV on annual valuation date and its initial high water mark value or previous NAV that charged performance fee.
Besides management fee, there are trustee/custodian fee, administration fee, audit fee, registration fee and legal fee. These fees in total are usually less than the amount paid to management fee.
To measure whether the operating expenses are reasonable, an investor can look at the total expense ratio (TER). A total expense ratio represents the fees paid to the investment manager and expenses incurred for fund administrative services. Usually expressed as an annual percentage of a fund's average net assets, these costs may range from under 0.25% to more than 2% of a fund's net assets.
As a fund investor, you should realize that, over time, sales commissions, high operating expenses, and excessive charges can consume a substantial portion of the return you earn on your fund investments. Investors can go through the fund annual report or total expense ratio (TER) provided by Morningstar for easy reference.
An investment manager may adopt top-down or bottom-up approach as well as a momentum or index tracking strategies.
1. Top Down Approach
In the top-down approach, the investment manager starts with studying the global economy. The manager looks at the inter-relation between interest rates, inflation, balance of payment, GDP growth and other economic data. He then proceeds to analyze the economic fundamentals of each country, then each industry, and lastly each company. A top-down manager analyze on countries first, then asset classes, and then types of industry, and lastly companies.
2. Bottom Up Approach
In the bottom-up approach, the investment manager reverses the selection process and starts with researching and analyzing the companies of interest. The macro economic factors serve to supplement the company research. Bottom-up managers are typically value investors. To pick companies with strong fundamentals, managers generally rely on a lot of financial ratios, such as price to earnings ratio, price to book ratio and return on equity etc.
3. Momentum Trading Strategy
Momentum trading aims to identify explosive share price moves for the purpose of capturing profits. When investment manager observes acceleration in a share's price, the manager will take a position in the direction of the movement (long or short) and make profit that the momentum continues in either the upward or downward trend. Momentum trading often makes use of technical analysis and momentum indicators to identify buy or sell signals.
4. Index Tracking
Index tracking fund is a type of passively managed fund that tracks markets or industries to provide returns closely linked with the performance of the index, such as European Index, North America Index, Hand Seng Index, Hang Seng H-Share Index and so on. One of the most well-known index tracking funds is the Tracker Fund of Hong Kong. Its investment objective is to provide returns that substantially correspond to the performance of the Hang Seng Index, so the fund manager manages the index tracking fund by adjusting the portfolio’s composition according to the Hang Seng constituent stocks to ensure its performance follows that of the Hang Seng index.
When the investment manager makes an investment decision, he will place an order (buy or sell a security) to a broker. The broker executes the order for the manager. The investment manager also informs the trustee/custodian of the trade. The trustee/custodian will then co-ordinate with the broker to check and match the trade, and to arrange payment of the deal and delivery of securities. The trustee/custodian will also check that the trade is in compliance with the requirements stated in the trust deed, prospectus or explanatory memorandum. Administrator is responsible for processing subscription and redemption of fund shares, dividend distribution and other operational activities of the fund. Transfer agent is responsible for keeping records of, and for communicating with, a fund's shareholders, typically this involves canceling and issuing the fund's shares.
An open-ended fund is a mutual fund or unit trust that does not have a fixed number of shares. The fund continually sells new shares to investors when they purchase and redeems those that are tendered by investors. The purchase and redemption prices of the fund are calculated based on the fund's net asset value.
A closed-end fund is an investment company that has a fixed number of shares outstanding. A closed-end fund is traded like other stocks on an exchange. A closed-end fund may trade at a discount (commonly so) or premium (rarely so) to its net asset value, depending on the supply demand dynamics.
While we cannot cover every circumstance that would warrant the sale of a fund investment (or any investment for that matter), here are some sound reasons for considering the sale of a fund:
1. The Fund's Investment Philosophy And Style Has Changed
Each fund has its investment objective and policy. A prudent investment manager should abide by these statements. If you have invested in a large-cap growth fund and fund has begun investing in smaller, riskier investments, it might be time to shed this fund. This can also operate conversely. When you observe that the fund invests in securities not in line with what the prospectus promises, you might consider shifting your money into a fund that more closely fits your investment objective.
2. The Fund Consistently Lags Behind
A single quarter or year does not make a bad fund; but if your fund has consistently lagged its peers, you may want to cut this one loose. Also, it is important to keep in mind that you have to make a fair comparison. Do not compare your bond fund against an Asian equity fund. Compare it against similar funds with similar objectives. If you find that your fund has underperformed its peer group over 1, 3 and 5 years it's probably a time to make a change.
3. Management Has Changed Hands
While this factor alone may not justify for selling your fund, it should send up a red flag for you to scrutinize performance more closely. Most funds have plenty of able managers ready to take the helm but you should be diligent in making sure that your new manager stays competitive with his/her peers.
The Investors' Protection Ordinance governs the protection of investors in Hong Kong. Please browse SFC website on Investors' Protection for details.