What is a Mutual Fund?

An investment fund (or a collective investment scheme) is an investment vehicle that allows a large number of people to pool their money together in order to invest in a range of different securities such as stocks, bonds, property or commodities. Funds have differing objectives such as to deliver a regular income or capital growth for the investor. Funds are grouped together into categories determined by this aim, their risk, and by where in the world the underlying stocks or bonds are from.

What is an ETF?

Exchange traded funds (ETFs) are similar to the funds mentioned the previous section in the sense that by holding one vehicle you would be actually holding different underlying securities except that they act like a share themselves. ETFs are openly traded on stock exchanges such as the London Stock Exchange in the UK or the Nasdaq in the US. Most ETFs aim to perform in line with a specific index (e.g. S&P 500) or commodity (like gold) and often have low management fees. An example of an ETF would be the Vanguard S&P 500 ETF (VOO) which invests in stocks that are part of the S&P 500.

Types of Mutual Funds

  • Every fund which is created would have a mandate written on the prospectus that provides the guidelines of what a fund manager can or cannot do in that particular vehicle.

 

  • The mandate will only change if there is an approval from unitholders of the fund. If this happens, the fund gives the option to unitholders to liquidate the position free of charge.

1. Equity funds (country; e.g. US Equity or regional; Emerging Markets)

2. Market Cap biased Equity funds (all cap or more specific)

3. Growth or Income oriented

4. Sector specific (Financials, Bio-tech, Healthcare)

5. Bond Funds – Govt, Corporate, High Yield (one or more countries, one or more currency)

6. Absolute Return (generate positive return irrespective of market conditions)

7. Property Funds (invest in direct or indirect property instruments (REITs or property equity).

8. Commodity Funds (directly in gold, oil, copper or commodity related instruments like mining shares or oil producing stocks)

9. Target date Funds (structured to address a capital need at some date in the future, such as retirement.).

10. Thematic Funds (Sustainable, socially responsible)

11. Mixed Asset/Blended Funds (different strategies/asset classes)

12. Fund of Funds

13. Index Funds (passive mgt, similar to ETFs but structured as funds)

What to look for when picking mutual funds?

1. Performance

Relative Performance

Looking at absolute numbers is helpful but in order to make sure that the investment is sound, you would need to know if the fund is actually overperforming the market/benchmark or not (i.e. the relative performance). For instance you might think that a fund which increased in value by 15% is a good thing. If on the other hand you notice that the fund is underperforming the benchmark by say 10%, it means that had you invested passively in an index your investment would have increased by 25% and not 10%!

Sector Averages (Peer Group analysis)

These are basically return figures reported in one figure which include a collection of average fund returns that would have the same objective as the fund you are analysing. Sector averages are generally compiled by data providers like Morning Star, TrustNet, City Wire and S&P.

Quartile Rankings

Fund managers generally also quote the Quartile Ranking figures which are basically a measure of how an investment is performing in its peer group. It is measured by ranking the performance of all the funds in a particular sector over any period, into four sections. The first (or top) quartile will be the top 25% in terms of performance, the second quartile will be the next 25%, the third quartile will be the next 25% and the fourth quartile will be the last 25%.

Sector averages and quartile rankings tend to provide a ‘fairer’ comparison because you would be comparing fund managers in the same sector with each other whereas with a benchmark you would be comparing the manager with an index which has no management or administration fees being taken for active management.

 

2. Risk/Return metrics

a. Standard Deviation

  • how much the return on a fund is deviating from the expected returns based on its historical performance.
  • A high value means higher degree of risk because the predictability of returns less certain

b. Sharpe Ratio

  • the excess return for any extra unit of risk
  • SR tells us whether portfolio returns are due to smart decisions or a result of excess risk
  • The higher the better (more than zero and highest as possible)
  • Negative SR means that a riskless asset performs better than the fund

c. Beta

  • Measures volatility against the market

B: 1 =price moves with the market
B<1 =price less volatile          B>1 = price more volatile

d. Alpha

  • Funds risk-adjusted performance relative to benchmark
  • Managers contribution to performance due to security selection or market timing
  • +ve alpha fund did better than benchmark on a risk-adjusted basis
  • -ve alpha, fund did worse than benchmark on a risk-adjusted basis

e. Information Ratio

  • fund manager's ability to generate excess returns relative to a benchmark
  • High IR, the more consistent a manager is

f. Tracking Error

  • the standard deviation of returns relative to its benchmark
  • The lower the tracking error, the more faithfully the fund is matching its index 

g. Max drawdown

  • Decline in value from highest peak

 

3. Other Considerations

• Age of the fund - Do you want a fund with an established track record or you want to get in early when a new fund is launched and hence maximising returns?

• Number of holdings - a fund which has fewer holdings is considered more aggressive than the one having a higher number of underlying instruments.

• Size of fund - This indicates the fund’s popularity and past success at attracting investors. However, some funds can be so large it’s difficult for the fund manager to run it. A small fund is sometimes easier to manage but might impose higher fees and contain more risk.

• Fund manager tenure - Consistent fund performance often relies on a fund manager having managed it for some time. Ofcourse ‘star’ fund managers can change jobs from time to time.

• Independent ratings - Companies such as Morningstar, Standard & Poor’s, TrustNet and CityWire provide independent ratings for funds’ performance, creditworthiness and consistency of management.

• Charges - Look closely at all the fund charges—are the ongoing charges excessive, are there penalties for withdrawing your money? Are the charges being levied on the income before paid out or on the capital?

Types of Exchange Traded Funds

a. Country/Regional ETFs:  iShares Core DAX UCTITS ETF tracks the performance of the DAX 30 in Germany

b. Foreign currency ETFs :  exposure to foreign currencies without having to complete complex transactions

c. Sector ETFs:  Financials, HealthCare, Consumer Staples, Technology etc. An example would be the Technology Select Sector SPDR Fund (XLK).

d. Commodity ETFs: In this case you are purchasing gold or oil but not physically. The ETF would have derivative contracts in order to emulate the price of the underlying commodity. An example would be the SPDR Gold Trust (GLD).

e. Style ETFs: particular investment style (value or growth) or market capitalization (large cap, mid cap or small cap). An example would be the Vanguard Large Cap ETF (VV).

f. Inverse ETFs: betting against the market, thus creating a short position in the portfolio.

g. Leveraged ETFs: outperform index they are tracking. if the tracked index rises by 1%, a 2X Leveraged ETF should increase by 2% and vice versa.

h. Bond ETFs: Not very popular. difficulty faced by Bond ETFs managers is that the tracking is more difficult since underlying bonds mature over time and hence the index will need to change its components much more frequently than a standard Equity index. An example would be the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).

i. Thematic ETFs

What to look for when investing in ETFs?

Rebalancing Frequency

Performance should be similar to index it is tracking

Size  of ETF (liquidity – bid/ask)

Trading near the market  open or close

Trade size

Be aware of ETFs constituents’ trading hours and liquidity

Keep track of  distribution dates

Watch for events that  could lead to market volatility

Use limit orders