|
Mutual funds are also sometimes known as open-end
funds. These are portfolios of securities, mainly stocks, bonds and
money market instruments. There are several important aspects of mutual
funds. First, investors in mutual funds own a pro rata share of the
overall portfolio. Second, the investment manager of the mutual fund
actively manages the portfolio, that is, buys some securities and sells
others. Third, the value or price of each share of the portfolio,
called the net asset value (NAV), equals the market value of the
portfolio minus the liabilities of the mutual fund divided by the
number of shares owned by the mutual fund investors. Fourth, the NAV or
price of the fund is determined only once each day, at the close of the
day. For example, the NAV for a stock mutual fund is determines from
the closing stock prices for the day. Fifth, and very importantly, all
new investments into the fund and withdrawals from the fund during a
day are priced at the closing NAV (investments after the end of the day
or on a non-business day are priced at the next day’s closing NAV).
The number of and assets in mutual funds grew significantly during
the 1990s. At this time, there was a significant shift by individual
investors from real estate and other tangible assets to financial
assets. Discretionary financial assets increased from 34% in 1989 to
44%. Households increased their preference for indirect ownership
through mutual funds over direct ownership of stocks and bonds. By the
end of 1999, mutual funds accounted for 28% of household discretionary
assets, up from 12% at the end of 1989. In addition, 85% of
equity-owning households held a portion of their stocks in mutual funds
in 1999, up from 50% in 1992 (Fabozzi, Modigliani, Jones & Ferri,
2002). From 1990 to 1999, the number of mutual funds also rose, from
approximately 2,900 to 8,000. According to the Investment Company
Institute, the assets invested in mutual funds have increased
significantly, from $134 billion to $6,846 billion in 1999 (Reid,
2000). Mutual funds must have a few advantages to which this
significant growth can be attributed. They are:
Advantages of Mutual Funds: Diversification: This is one of the
primary advantages of a mutual fund and is one rule of investing that
both large and small investors should follow. An effective risk
management technique, investors can mix investments within a portfolio.
For example, if an investor buys stocks in the retail sector and then
offsets them with stocks in the industrial sector, he has reduced the
impact of the performance of any one security on his entire portfolio.
A truly diversified portfolio is one which contains stocks with varying
capitalizations and from different industries and bonds with different
maturities and different issuers.
While this may be a tall order for an individual investor, a mutual
fund facilitates this. When an investor purchases mutual funds, he is
given the immediate benefit of instant asset diversification and
allocation without spending a lot of money on creating an individual
portfolio. Hence, the investor has readily diversified with minimum
investment. As a stock mutual fund invests in many stocks, if a few
securities in the mutual fund lose value or become worthless, the loss
maybe offset by other securities that appreciate in value. The
opportunities are endless: an investor can engage in even further
diversification by investing in multiple funds which invest in
different sectors or categories. This helps to reduce the risk
associated with a specific industry or category (Mutual Fund Fact
Book).
Economies of Scale: Economies of scale is a concept which perhaps
can be best understood by an example. It is denoted by the way volume
discounts work: a lot of stores have this offer that the more of one
product that a customer buys, the cheaper that product becomes. Like
the price per doughnut is usually lesser for a dozen doughnuts than for
a single one. This concept also holds true for the purchase and sale of
securities. If an investor buys only one security at a time, the
transaction fees will be comparatively higher.
Mutual funds enjoy this advantage due to their buying and selling
size and in this way; they reduce transaction costs for investors. When
an investor buys a mutual fund, he can diversify without the various
commission charges associated with the transaction. If he would have to
buy 10-20 stocks needed for diversification, the commission charges he
would have to pay would be huge and also, every time he would want to
modify his portfolio, he would have to pay additional transaction fees.
Hence, with mutual funds, he is able to make transactions on a much
larger and cheaper scale (Mutual Fund Fact Book).
Divisibility: This is another advantage that mutual funds offer.
Often, a lot of investors don’t have the exact sums of money to buy
lots of securities. At most times, a mere $100 or $200 is not enough to
buy a round lot of a stock, especially after paying commissions as
well. With mutual funds, investors can purchase securities in smaller
denominations, ranging from $100 to $1000 minimums. Investors no longer
have to wait until they have enough money to buy high-priced
investments. This factor is related to the next advantage on our list
(Fabozzi, Modigliani, Jones & Ferri, 2002).
Liquidity: Mutual fund shares are highly liquid and orders to buy or
sell are placed during market hours. But, it should be remembered that
orders can not be executed until the close of business when the NAV of
the fund can be determined. Professional Management: The professional
management that a mutual fund offers is definitely an important
advantage. The investment professionals, who manage and supervise the
mutual funds, decide when to buy or sell securities according to the
stated objectives in the prospectus, prevailing market conditions and
other factors. Hence, the investor does not have to deal with the
hassle of trying to time the market. Also, the investor does not have
to deal with the cost of following the ode of due diligence when
researching securities. On the contrary, this and the other costs of
managing numerous securities is divided among all the investors in
proportion to the amount of shares they own with a fraction of each
dollar invested used to cover the expenses of the fund (Fabozzi,
Modigliani, Jones & Ferri, 2002). Mutual funds are also highly
convenient because buying and selling shares, changing distribution
options, and obtaining information can be accomplished conveniently by
telephone, by mail, or online. They are not without disadvantages
though. There are a couple of reasons due to which the growth of mutual
funds has been slowing recently.
Disadvantages of Mutual Funds: Fluctuating Returns: At the end of
the day, mutual funds are like the many other investments without a
guaranteed return. The possibility of the depreciation of the value of
the fund is always present. These funds are an example of variable
income products and unlike the fixed income products (such as bonds,
treasury bills), mutual funds experience value and price fluctuations
in accordance with the stocks that comprise the fund. A thorough
research of the inherent risks is necessary and it should not be
thought that the supervision of a professional manager is the guarantee
of a high-performing fund.
Another glaring disadvantage of mutual funds is that they are not
guaranteed by the U.S. Government, so in the case of dissolution,
investors do not get anything back. This counts for a lot in the view
of investors in money market funds. A bank deposit would be FDIC
insured, but a mutual fund does not have any such backing (Fabozzi,
Modigliani, Jones & Ferri, 2002). Diversification?
This was present in the list of advantages but also makes its
appearance here. Diversification might be necessary for successful
investing, but a lot of mutual fund investors tend to take it to the
extreme. The concept behind diversification is to reduce the risks
associated with holding a single security; but when investors
over-diversify (or engage in a process also known as diworsification),
they acquire many funds that are highly related and in this way, do not
enjoy the risk reducing benefits of diversification. Another key point
in this regard is that ownership of mutual funds does not mean
automatic diversification. For example, a fund that invests only in a
particular industry or region is still comparatively risky (Mutual Fund
Fact Book).
The cash aspect: The liquidity aspect of mutual funds can also work
against it sometimes. Since mutual funds pool money from thousands of
investors, there is a lot of cash activity happening everyday as
investors put money into the fund and withdraw investments. In order to
maintain ample liquidity and the ability to withstand withdrawals from
the fund, funds usually keep a large portion of their portfolio as
cash. This cash is dormant; it provides liquidity but does not work for
investors and hence, can not be very advantageous (Fundamentals: Mutual
Fund research in brief).
Costs of the mutual fund: The professional management which mutual
funds provide comes at a cost. There are two types of costs borne by
investors in mutual funds. The first is the shareholder fee, usually
called the sales charge. This cost is a one-time charge debited to the
investor for a specific transaction, such as purchase, redemption or
exchange. The type of charge is related to the way the fund is sold or
distributed. The second cost is the annual fund operating expense,
usually called the expense ratio, which covers the fund’s expenses, the
largest of which is for investment management. This charge is imposed
annually and is assessed to mutual fund investors regardless of the
performance of the fund. So, for the years when the fund doesn’t make
money, these fees only magnify losses (Neil, 1999).
Misleading Advertisements and problems in evaluating funds: The
misleading advertisements of some funds tend to show investors down the
wrong path. It is common practice to label funds as ‘growth’,
‘small-cap’ or ‘income’ funds, when these labels might be inaccurate.
The requirements of the SEC calls for funds to have not less than 80%
of assets in the specific type of investment implied in their names.
The remaining assets can be according to the fund manager’s discretion.
The loophole comes in because the different categories that can be
taken for the required 80% of the assets may be vague and very general.
Hence, some funds often manipulate prospective investors by using
misleading names such as ‘growth fund’ in place of a ‘small cap’.
Evaluating a fund is a difficult enough task in the first place because
in mutual funds, there can be no comparison of the P/E ratio, sales
growth, EPS, etc. The NAV of a fund does not imply which fund is better
than another. Also, advertisements, rankings and ratings by agencies
are based on past performance, which are no indicators of future
profits or losses. Hence, investors need to be extremely careful when
evaluating a mutual fund to invest in (Fundamentals: Mutual Fund
research in brief).
The growth of mutual funds might be slowing down to the
disadvantages given above. For a lot of investors however, the
advantages offered more than make up for the cons. At the same time,
the entry of a high proportion of potential investors, the advent of
Exchange Traded Funds and other mutual fund alternatives have and will
affect the growth of mutual funds.
|
|
|
(0 vote)