What is a Fund

A mutual fund is a collection of stocks, bonds or other securities owned by a group of investors and managed by a professional investment company. A typical stock fund might own stocks in over 100 companies providing a wide range of products and services. Profits are made by the fund by earning dividends on its investments, or by selling investments that have increased in price. The funds’ investors have to pay the fees and expenses of the organization that runs the fund, which are justifiable if the fund performs well. In the US there are over three hundred fund groups offering several thousand different funds with total fund assets of around two trillion dollars. Globally there are twice as many funds whose total assets are in excess of $3 trillion.

Types of Funds

There are three main fund categories namely: Stock or equity funds, bond funds and money market funds. The risk of the different funds varies depending on the risk of the individual components of the fund. An equity fund can invest in a market index — index fund, or in a selected number of companies. An index fund invests in the same ratio of companies that make up the particular market index. Accordingly it does not require any active management, and hence it’s management fees are either zero or very low. By definition, its’ performance should be identical to the performance of the index.

An active mutual fund invests in a number of companies, which are selected by the fund manager and his research team, based on good prospects of the selected companies. Such funds have a specific focus or identity based of the level of risk, type of industry, size of companies, location of companies, growth rate, income, and so.

The objective of equity mutual funds is to outperform the market and they are supported by an extensive equity research team. These funds usually charge a high management fee which range between 2-5 percent of the invested amount.

The third group is bond funds, which invest in selected bonds. The average return of each of the above fund categories varies and is directly related to the level of risk that the fund carries.

Why Invest in Funds

A fund provides diversification, which in turn reduces investment risk. However diversification is expensive for the smaller investor, besides proper selection of the instruments to buy is time consuming. In a fund, pooling the money of many investors create a big buying power. Because of the large number of holdings they have, professional fund managers keep constant tabs on the markets, adjusting the portfolio for the strongest possible performance. Getting in and out of funds is expensive, hence the biggest challenge of a fund investor is to select the right fund that is able to perform and achieve the established target.

Performance

Fund’s performance vary dramatically and consequently have a strong relationship to the flow of cash in or out of the fund. Although mutual funds charge high fees for their services, however their performance is not always as good as desired. A quick review of mutual funds performance during the past several years reveal that a small percentage of the funds did well, i.e. over-achieved the stocks or bonds indexes, while the rest under-performed the average.

Funds Selection

Overall there are two main categories to select from, active and passive. Passive funds invest in various indices, charge low management fees and usually outperform active funds. Active funds invest in equities that are expected to provide the best performance among their peers and accordingly are associated with high expectations. More money is invested in active rather than passive funds, despite the superior historical performance of the latter.

This provides evidence that most investors believe that some mutual fund managers have the ability to consistently beat the market. In addition many investors focus on the upward opportunity and try to get it without thinking of the associated risk. Prior to choosing a fund, one has to identify his or her investment objectives. This includes matters like risk tolerance, income or growth focus, and selection of particular industries or companies that one wants to invest in.

Historical funds’ performance is important, however matching future results with previous achievement is not guaranteed. In addition to historical performance, one has to look at the experience of the fund manager, the size of the fund, fund management fees, and possibly the prospects of the main companies that the fund owns. The percentage cost of trading funds is more expensive than trading shares. Accordingly a fund investor should plan to remain committed to a fund for a longer period than the stock investor.

(Salim J. Ghalayini, [email protected], is the author of “Stocks for the Practical Investor”. He manages several investment accounts.)