Mutual Fund | Definition, Types, How to Choose?

Mutual Fund | Definition, Types, How to Choose? – Mutual fund is a financial product that invests in stocks or bonds. It is a pool of money accumulated by investors and managed by market professionals. Owning a mutual fund is like getting smaller slice of an apple. Investors get units of the fund in proportion to their investments. Suppose a mutual fund has total assets of $5000 and someone invests $500, he/she will get 10% units of the fund.

fidelity-mutual-fund

source: Fidelity

In this detailed post, we do an in-depth analysis on Mutual Funds, Types, Investment approaches and more.

 

Why Invest in Mutual Fund


Individuals, corporations, small businessmen etc. who wants to invest in stock market but does not have expertise and time to do so can invest through mutual fund. Some key benefits of investing in a MF

#1 – Professional Management

Portfolio Manager” invests money on investor’s behalf with a responsibility of growing it and making profits for unit holders. So investors don’t need to be an expert on stock fundamentals or market technicalities. Portfolio manager perform research to unveil new profitable stock ideas. He keeps tab on economic activities in regions / countries and accordingly decides his investment exposures.

Most of you know Warren Buffet. He is legendary manager outperforming market index for many years. He employed valuations and quality based approach to investing. We will discuss different investment styles in below section.

#2 – Diversification

Mutual fund provides diversification by investing in variety of stocks. Imagine you want to buy a Google stock which will cost you ~$800 for one stock so it is expensive. Now think of investing $800 in a MF, that holds Google stock along with many other stocks. This is very important advantage in investing through a MF.

A typical portfolio holds between 40-100 stocks depending on manager’s objective. A manager invests in stocks of various industries or countries to reduce risk of losing the money. See below T Rowe Price Emerging Market fund example for diversification.

t-rowe-mutual-fund

source: T.Rowe

The fund has invested more than 80% of money in top 10 countries like China, India, and Brazil etc. Similarly across different sectors with highest in IT, financials and consumer staples. This provides diversification to investors with less money.

#3 – Liquidity

Investing in mutual fund can be consider as closer to holding cash as investors can sell the units anytime and receive cash. Portfolio manager always keep cash handy for redemption requirements. So if you place a sell order today, you will get cash in next one or two days. The fund documents generally mention the settlement period e.g. T+2 means 2 days from trading day (T). A portfolio manager also invests portion of money in stocks which he can easily sell to meet redemption requests.

#4 – Ease of Investing & Affordability

Investing in a MF has become less painful over the years with the help of technology. Anyone can buy a fund by simply visiting the fund or broker website. One can buy and sell a MF and perform tasks like generating a statement, making incremental investments at a click of a button.

Investing in a mutual fund is not very expensive. To open an account minimum amount could be a $1000 or less. For incremental purchases the minimum amount is $100. Also investors have a choice of investing in a fund through options like systematic investment or withdrawal which could be used for regular saving or to meet expenses.

Types of Mutual Funds


Various types of MF’s are available to cater the need of investors with different financial goals and age groups. They have different investment objectives and risk profiles.

types-of-mutual-funds-v1

#1 – Active vs. Passive Funds

Both the investment approaches differ in how manager wants to invest money and generate returns for account holders. Active funds seek to outperform a specific benchmark it has set for itself such as S&P 500 or BSE Sensex. To achieve this, active funds buy and sell stocks and manager pay attention to factors like economy, political situations, and other trends. He also does research around stock specific factors like ratio analysis, earnings growth, cash flow available to shareholders and future financial projections etc.

Passive funds on the other hand try to mimic the holdings of a particular index to create similar returns. Manager buys index stocks and applies same weighting. The objective here is not to beat the index but to remain closer to it. Since index funds require less research and other operational activities, the cost of buying it is less than an active fund.

In the United States, Vanguard, Blackrock etc. primarily offers only passive funds like Index funds and ETF’s. On the other hand Fidelity, T Rowe Price etc. offers many suits of active funds.

In last five years, passive funds saw lot of inflows and their assets under management increased many folds on account of lower fees and better performance than active funds.

mutual-funds-risk-vs-returns

#2 – Equity Fund

Invests in common stocks of companies listed on stock market. The primary investment objective of this class of funds is long-term capital growth. Equities are high risk, high reward asset class. They can be best suited to people with high risk taking ability and looking for higher returns.

t-rowe-stock-market-fund

source: T.Rowe

There are multiple types of equity funds being offered

  1. Sector funds– Most risky of the lot, these funds invests in particular sector in the economy e.g. IT sector fund will invest in technology companies only.
  2. Region or Country funds– Manager invests money in particular region such as Asia, Latin America or Europe or in specific country like the Unites Stated, India or China. This is slightly lower risk fund than sector fund.
  3. Large, Mid & Small Cap funds– Investment objective is to invest in particular market capitalisation companies such as large cap funds will invest in blue chip big stocks only, while small cap fund will invest in stocks with say less than $1 billion market cap. The riskiness decreases with increase in market cap.
  4. Diversified Funds– Less risky, as investment spread across sectors, regions, countries and market caps. Manager of this fund requires more skills and knowledge than any other above mentioned types. So selecting a right fund could be challenging. I will try to explain it to readers in “how to choose a Mutual fund” section.

 

#3 – Fixed Income Funds (FI)

Synonyms as bond or debt fund are less risky option of investing than in equity fund. The primary objective is to provide steady cash flow to investors. Investment happens in government and corporate debt securities.

t-rowe-fixed-income-funds

source: T. Rowe

These are more suitable for people with risk aversion or reaching their retirement age etc.

  1. High Yield funds– Carries highest risk within FI funds due to their investment in junk bonds. Junk bonds are lowest rated bonds (BB or below) by credit rating agencies such as S&P or Moody’s. Provides attractive returns than most other fund types in this group.
  2. Corporate Bond funds– Companies borrow money at a fixed interest / coupon rate. Mutual fund manager invests in these securities and receives steady cash payments.
  3. Government Bond Funds or Gilts– Lower risk fund in this group. Invests in government securities like treasury bonds, notes or gilts etc.
  4. Money Market Fund- Lowest risk funds that invests mostly in treasury bills. Return will be less than other type of FI funds but the risk of losing the money is also negligible.

 

#4 – Balanced Funds

These are known as hybrid funds. Portfolio holds both equity and debt securities. Primary objective is to gain capital appreciation and generate income for investors. A typical balanced fund invests a 60% in equity and a 40% in fixed income.

t-rowe-balanced-fund

#5 – Alternative Funds

These funds are non-conventional investment vehicle unlike stocks and bonds. High net worth and institutional investors are predominantly using this MF type. Due to its complex nature individual investors are not advised to sign-up for these funds. Alternative Investments funds invest in real estate, commodities, derivative and futures contracts, and also in hedge funds.

Investment Objectives


Kid’s college education or marriage, retirement planning or medical expenses are some of the things many of us are planning through our working lives. I would like to list few investment purposes below that may help readers in making investment decision.

Goal Based Investing

As mentioned above, one can plan the future expenses and invest accordingly. Many fund complexes offer “Target Date Funds” or customised “Fund of Fund” which basically allocates the assets to equity and bond MF’s. Difference between two is target date funds are non-discretionary i.e. investor can only invest in one of the available plans and can’t choose the exposure according to his/her needs. Fund of Funds could be dynamic and invests according to target asset mix suitable for investors after looking at his/her risk profile and liabilities etc.

However, the mix will be rebalanced as the holder is approaching to the target date. The basic rule is to invest more money in equities and as a holder grows old; allocate more money to debt mutual fund e.g. at 30 years old investor should invest a 30% in debt and a 70% in equities (this is a thumb rule).

fidelity-goal-based-mutual-fund

source: Fidelity.com

Investment Growth

Investors who are retirement ready and looking for aggressive returns can do so by taking some extra risk. Mutual Fund sufficing this objective invests money in fast growing companies like small caps or companies with positive trends in stock price (price momentum) etc.

Tax Savings

Mostly wealthy clients, Institutional investors and corporates have an objective to minimize the tax outlays. Taxes can eat into returns making it negative or trivial. Citing the importance of after-tax returns, few products can help investors gaining the ‘tax alpha’. These products are built by combinations of MFs, Index funds or ETF’s and stocks or bonds. Typically individual account is handled by an investment manager who knows the long and short term tax implications. Buying and selling is driven by tax alpha gains.

Suppose you are holding fund A and Fund B then

  • If you have capital gains in both A&B, you will be taxed for both at applicable income tax.
  • If you have a capital gain in A and loss in B, then you can set off the losses against the gains of A and thus reduce the tax liability.

Thus by taking appropriate exposures, tax outgo can be optimized to produce overall gains in An account.

How to Choose a Mutual Fund


After knowing types and purpose of investment, the next big task (crux of this article) is to choose the fund that can help in achieving your investment goal. In this section, we will delve in to more details about style and approach, overall portfolio manager investment strategy, list of things one should pay attention before investing in a fund and other exogenous factors to consider. So let’s begin with

#1 – Investment Approach

This section basically deals with how manager decides to invest money in a country, region or sector.

  1. Top-down investing- Manager using this approach, first decides a country or region, he wants to invest in. Second, he does deep study of the economic drivers for the country e.g. United States is a consumption driven economy. Third important step is to decide on sectors or industries that are benefiting and in the last part; he does stock selection and portfolio construction.
  2. Bottom-up investing- It is complete reverse of above approach, in this manager believes that superior stocks selection and portfolio construction will lead to good returns. Research is focused on unveiling good stock ideas that can sustain their performance through the periods of economic turbulence.
  3. Quantitative investing- Algorithmic trading of stocks through computer on pre-decided factors screening and ranking. Typically these factors are combination of valuation (PE ratio or PB ratio), momentum (price and earnings), reversion (earnings revision) and trading sentiments etc.
  4. Quanta mental investing- It is a combination of above approaches i.e. fundamental (top-down or bottom-up) and quantitative.

#2 – Fund Style

This is very important consideration before investing due to its direct mapping with the risk involved in each style. Readers may be aware of a) Growth b) Value c) Core or Blend styles; however, this can be further divided into more granular sub-styles. It can be better explained by following charts

Mutual Fund style

The horizontal axis in both the charts represents the categories, based on valuations of each stock holding in a fund. Valuation metric used are price-to-earnings (P/E), price-to-book (P/B) ratios etc. such as lowest P/E and P/B stocks falls under the value style. Growth stocks rank higher on P/E or P/B ratios.

The vertical axis in Morningstar style box is divided by market cap. Underline stocks are ranked to determine overall market cap for the fund. So for example, large cap growth fund is investing in high P/E or P/B ratio stocks that also has high market cap (blue chip companies).

The chart on the right side talks about prominent sub-styles within each category. The vertical axis shows risks of styles, based on their deviation from the benchmark returns (standard deviation), beta (a measure of fund/stock sensitivity with the overall market) and other stock specific factors. A deep value fund is one that invests in cheap (in terms of low P/E or P/B ratios) and ignored stocks by market participant but has potential to appreciate in future.

#3 – Investment Strategy

  1. Buy and Hold- It is a long term investment commitment by ignoring short-term volatility in stocks. Buy and hold strategy is not a passive investment but it is based on fundamental analysis. The manager believes the set of stocks he holds, could produce good returns over the long run.
  2. Opportunistic- The core idea of this strategy is to take advantage of market actions/ movements. Manager frequently buy and sell stocks to gain exposure to sectors or industries which he thinks are going to do better in near term. Another sub strategy could be a momentum investing. Momentum investor follows trends in stock prices or earnings and buy stock that are showing uptrend. Selling of stocks also done by looking at down trending in prices. Cost-wise, opportunistic strategy is more expensive than buy and hold due to frequent trading.

#4 – Four P’s of Investing

After reading through this long, reader may have got a brief idea about mutual fund types, investment strategies and style etc. In this section, I am discussing on how to assess good portfolio managers and what are the characteristics of a good fund. I must say, some of it may not be doable by just reading about the fund and commentaries but by using a sound judgement. Let’s take a stab at it

  1. People- People managing the fund are portfolio manager and research staff working with him. Investor should always be more concern about who is managing his money. Setting investment directions and making profits for investors is the most important function in entire process. So before investing few questions should help in making decision. What is portfolio manager total experience? Since how long he is managing a particular fund? What is the performance record especially during rising or falling market? Quality of research staff etc.
  2. Philosophy and Process- It’s a framework for investing. This is the mandate of investing that controls every action of a management team. I would say this is very important ‘P’ that investors can’t get more information on by reading fund documents. However, as we discussed in fund style section, one can assess the style of the fund and riskiness which is implied by its process of investing.
  3. Positioning– Fund positioning or holdings are disclosed every month or in three months for public view. A deviation in exposures or weights in stocks, sectors, countries or regions, highlights manager’s conviction. Investors can judge if manager is following the mandate of investing or not. See below example of positioning disclosure

fidelity-emerging-market-fund

  1. Performance- Performance track record should always be looked relative to market or set benchmark. For simplicity purpose, investors are recommended to invest in a fund that has at least 3-5 years of track record. Fund producing superior performance after adjusting for the risks it takes are the one should be given due credit. Performance analyses can be performed by segregating it through different periods for example how the performance of a fund evolve during financial crisis of the year 2008 and the subsequent rise of the markets in 2009. It is difficult to assess whether the fund performance is by luck or by manager skills, however, paying attention to factors like changes in positioning or risk profile, can deal with some of that.

#5 – Expense Ratio

Calculated as total operating expenses over fund’s average net assets. The operating expenses include compliance, fund management, marketing, record-keeping and other costs. Investor should particularly pay attention to this ratio because it can impact the returns of the fund. Expense ratio is generally disclosed annually. Active funds have more expense ratio than passive. Also equity funds are more expensive than debt funds.

Conclusion


Investing in a mutual fund is a science and I tried addressing some of the jargon and techniques in above sections. Going by the flow, investors could follow some basic investing rules like

  • Age of investing decides allocation in equity, debt or alternative funds. Younger you are more you can invest in equities.
  • Liabilities assessment and future expenses
  • Risk tolerance- e.g. high risk taking ability then invest in aggressive growth or deep value or alternative funds
  • Choose a MF that suits your needs
  • Build a diversified portfolio- allocate money to each class of funds
  • Keep an eye on the performance etc.

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