Instant Diversification with Mutual Funds

If you’ve read other articles offered at Buy Shares than you’re probably aware, the most common topic we address is the importance of diversifying your investment portfolio. For many investors, there are no better ways to do this than mutual funds and/or ETF investments. Both these fund type investments offer instant diversification across a wide spectrum of investments, but each has its own specific advantages and disadvantages against the other. In this article we will take a look at some of the key features of mutual funds while we will delve into ETFs in our next article.

Mutual funds, sometimes simply called funds, are considered by many to be the cornerstone of any investment portfolio. It is quite possible to build a very solid, profitable portfolio just by using funds, and mutual funds are one of the best investments available to new investors. There are a number of reasons that they are such a great option, but perhaps the most important is the diversification aspect of mutual funds.

What is a Mutual Fund?

A mutual fund is often referred to as a pooled investment. What that basically means is that one fund contains a wide array of investments. In purchasing a quality mutual fund, you would then own the equivalent of very small shares in many different companies, usually dozens or even perhaps a hundred or more in one fund. In reality, you do not own any of the shares of the individual companies, only shares in the fund.

The fund is controlled by the fund manager, who oversees the day to day trading and activity of the stocks in the fund. His job is to execute the fund’s objective, which may include goals such as aggressive growth, high dividend yields, or slow and steady growth and income. The fund will also have an outline for the types of investments that the manager may make, such as in domestic or foreign equities (or both), income investments like bonds and gilts, commodities and derivatives, or any combination of these and other investment types. Whatever the rules, they will be laid out clearly in the fund’s prospectus, which must be issued to each investor prior to or upon purchase. This is somewhat of a guide book to the fund and thoroughly explains, along with the fund’s objective, its fees, manager’s profile, price and earnings history and top holdings, among other things. The prospectus should be reviewed before agreeing to purchase any mutual fund and any questions about it should be answered before deciding on the fund. Although it can be quite a large document, the important features can be scanned and understood in order to make an informed decision. These most important sections include the fund’s objectives, strategies (how it will achieve its objective), performance history, risk strategy, distribution policy, manager profile and the fund’s fees and expenses.

Mutual Fund Fees

The fees and expenses are one of the areas of focus for most investors, and rightly so. They can eat away at the fund’s gains and an otherwise attractive fund can be ruined by high expenses and fees. When purchasing a fund, there are several different fee options. You may pay a purchase fee up-front, called a front-end load, you can pay the fee when you sell the fund, called a back-end load, or you may purchase a fund with no sales fee, called a no load fund.

The back-end load fund is the least common of the options and is not often used. Front-load funds are sold most often through investment advisors and stockbrokers. They will generally receive a commission on the sale along with a small residual commission through the fund’s annual fees. This is how the broker makes money selling funds and for the most part it is a fair system and many front-end funds are quite good and valuable assets to own. However, there should be no confusion over the fee. The stockbroker should explain in detail what the fees are, how they are paid and why. The broker’s failure to disclose the fact that the he is paid commission from a front-end fee is questionable at best and if your broker refuses to discuss it at all, then it may be time to find a new stockbroker. A quality broker will be honest and up-front about it and should have little problem at all explaining the fees, the commission, and the benefits of purchasing their recommended front-end load fund.

Front End Load vs. No Load Mutual Funds

Many people might wonder why anyone would purchase a load fund when no-load funds are available. Much of the time they would be absolutely correct. However, another important aspect of any mutual fund is the expense ratio. The expenses come from paying managers, sales fees, and trade expenses within the fund, among other things. While a no-load fund will seem attractive, one with large annual expenses can actually be a worse investment than one with a front-end load.

For example, take two funds, Fund A and Fund B, both with pre-expense gains of 6% per annum. Fund A is a no load fund with annual expenses of 1.3%. Fund B has a front-end load of 5% and annual expenses of .6%. As you can see in the chart below, after 5 years, Fund A, with no load, has earned £20.80 more than the front-end load fund.

Mutual Fund Investments

However, when we continue the investment out a bit further, we will see that eventually, the front-end load fund will overtake the no load fund, thanks to the smaller annual fees.

Mutual Fund Fees

By the end of year 7 the funds are nearly equal and after year 8, the expenses have eaten away at enough of the gains that the front-end load fund has now earned £8.13 more per £1000 invested. This amount will only increase over time and the breakeven point may come even earlier depending on factors such as the interest rate or the expense ratios.

Of course an example such as this is extreme and this does not mean that all front-end load funds will outperform no load funds over time. It does however show the importance of the annual expense ratio in comparison to the one time sales load. It is absolutely necessary to recognize the role that expenses can play and take into account all of the information available in the prospectus, not just the sales charge.

Mutual Fund Savings Plan

Most mutual funds also usually have automatic investment plans, which allow for small investments over a long period of time. This really helps investors make a savings plan they can commit to and in many cases will lower the average price paid for the fund over time, a strategy called pound cost averaging. It does so by committing the same amount of money in each purchase, which will naturally allow for the purchase of more shares when the price is low, while purchasing fewer shares when the price is high.

An example would be if two investors were to purchase £1000 worth of shares in a mutual fund that had a current price of £10 per share. Investor A purchases 100 shares straight away and pays £1000 for an average price of £10 per share of course. Investor B spends £100 per month for 10 months (also £1000 total). If the monthly sales prices were as follows – January £10, February £11, March £10.50, April £9.50, May £9, June £8.50, July £9, August £10, September £11, and October £12, then Investor B would have purchased 100.55 shares at an average price paid of £9.95 per share, even though there were months where he paid more than £10 per share. Yes this is a small amount, but over a longer period of time this price difference could potentially be much greater. There is no guarantee of lowering the overall price paid with pound cost averaging, but most of the time it is a great long term investment strategy.

Mutual funds can indeed be the cornerstone upon which an entire investment portfolio is built. With the breadth of fund options and investment strategies available, it would even be possible to invest only in mutual funds and be very comfortable doing so. The most important keys to investing in funds are to understand the fund’s objective, strategy and risks, be comfortable with the fund manager (long tenure is best), estimate potential gains by evaluating long-term historical data, and keep expenses in check by choosing cost efficient, low expense funds.

A similar type of investment is covered in our next article: ETFs.