Your Beginner’s Guide To Mutual Funds

What are Mutual Funds?

A mutual fund is an investment vehicle that allows various investors to pool their funds together to invest in assets under a common investment objective, managed professionally.

This objective is established through the  respective funds’ mandate, which fund managers are not allowed to deviate from. When an investor buys into a mutual fund, he/she essentially owns a proportionate share of the assets held under the mutual fund.

What types of mutual funds are there?

Due to the vastness of the world of mutual funds, there are many different categories and sub-categories of mutual funds. For simplicity’s sake, we will be delving into only the main categories of mutual funds.

Money Market Funds: These funds mainly focus on short-term debt instruments (e.g. treasury bills, certificates of deposit, commercial paper, etc), which may originate from both corporate and government entities. Generally, money market funds aim to generate income for investors at a low risk, however, this comes with the cost of lower returns than other fund types.

Fixed Income Funds: These funds invest heavily in long-term debt instruments, specifically bonds. Given the seniority of debt over shares within the capital structure, fixed income funds typically offer investors a relatively low-risk investment in the long-term.
Nevertheless, the fund’s assets may vary from investment grade bonds to high-yield bonds (aka junk bonds). As such, it is crucial for investors to exercise prudence and evaluate the credit ratings of bonds held within each fund, according to one’s personal risk appetite.

Balanced Funds: As its name suggests, balanced funds aim to strike a balance in the proportion of assets it holds, usually between debt instruments and individual stocks. This method offsets the relatively higher risk of holding only individual stocks, thereby reducing and balancing the risk for investors.

Equity Funds: These funds focus solely on holding individual stocks, usually focusing on companies within a particular industry in a particular geographical location (e.g. US Steel). The strategy employed varies between different funds, thus the fund manager typically screens for stocks to be included under the fund based on predetermined criteria.

Alternative Funds: As its name suggests, these funds tend to focus heavily on alternative investments (e.g. commodities, real estate, derivatives, etc.). These funds aim to provide investors with an additional layer of diversification, and may be used as a hedging tool due to its low correlation with conventional asset classes. Due to the significant complexity of alternative investments, these funds are typically only available to accredited or institutional investors.

How are mutual funds structured?

There are only two structures to mutual funds in the market:

Open-end: Open-end funds do not have a limit on the number of outstanding shares issued to investors. Shares are created when investors subscribe to these funds, and removed from circulation upon redemption.

Closed-end: Closed-end funds maintain a fixed number of outstanding shares available to investors. Closed-end funds are typically launched through an IPO (initial public offering) similar to company shares, where the fund managers issue a predetermined number of shares to investors, which is known as the primary market. Once the shares are completely purchased by investors, the fund manager ceases to offer new shares. Instead, interested investors may purchase shares of the fund from existing shareholders looking to sell their shares, thereby creating the secondary market for the fund’s shares.

What are the returns of mutual funds?

Capital Gains: With a proper investment strategy adopted, the underlying assets held under most funds would appreciate in value, which increases the value of shares of the respective funds.

Dividends: Debt instruments with regular coupon payouts and dividend-paying shares enable the funds holding such assets to provide investors with a recurring dividend income.

Price Arbitrage: For alternative funds holding assets in futures contracts, investors stand to gain from the pricing differences between the spot and futures markets as a result of market inefficiencies.

What are the costs involved in mutual funds?

While mutual funds are generally considered to be low-cost investment vehicles as compared to direct holdings of individual company shares, it is crucial for investors to understand the various fees and charges involved.

Initial Sales Charge: Also known as the upfront load, this one-off charge is levied on investors upon the subscription of a new mutual fund, and is usually a percentage of the initial investment amount.

Account Maintenance Fees: Depending on the account holding the assets, the respective financial institution involved may charge a fixed maintenance fee if the value of the funds and/or assets held within the account falls below a certain minimum requirement.

Total Expense Ratio: The TER is a measure of the total operating and administrative costs involved in the management of the fund. Components of the TER mainly include management fees, trading fees, and other operating expenses. The TER is charged annually as a percentage of the value of assets owned by investors. Generally, actively-managed funds charge a higher TER due to the higher professional management expenses and trading expenses incurred.

Performance Fees: In actively-managed funds, one hurdle to be overcome is the predetermined performance benchmark set over a period of time in order to earn a performance fee, which is charged as a percentage of the above-benchmark returns. This creates a stronger incentive for the fund manager to outperform the hurdle, but may result in excessive risk-taking as well.

Switching Fees: Due to changes in market outlook, investors may decide to switch to other funds periodically as part of their investment strategy. Most fund families levy a one-off charge to cover the administrative costs for the switch.

Redemption Charges: Similar to initial sales charges, redemption charges (aka back-end load) are levied upon the redemption of shares in the fund.

How are the prices of mutual funds determined?

For open-end funds, prices are determined by adopting the forward pricing methodology, where investors submit their transaction orders to the respective funds throughout the day. At the end of the day, after the market closes, these funds consolidate all transaction orders to determine the closing price of their respective fund shares, which is also known as the Net Asset Value (NAV) of the fund. All transaction orders submitted throughout the day will therefore trade at this closing price, also known as the forward price.

On the other hand, for closed-end funds where shares of funds are limited, this creates a secondary market in which they are traded similarly to stocks. Prices are therefore determined by market forces (supply & demand), which are affected by investors’ sentiment and market outlook.

What are the benefits of investing in mutual funds?

Economies of Scale: Due to the significant size of the funds pooled together under a mutual fund, investors are able to enjoy the benefits of lower transaction fees due to the transactions being made in bulk.

Diversification: With assets held under each fund varying by their geographical location and industry sector, investors are better able to spread their risk without much effort when they invest in mutual funds. Should any one of the underlying assets perform poorly, the overall portfolio performance has less risk of suffering significantly.

Liquidity: Liquidity refers to the marketability of the asset in conjunction with its ability to transact near/at its current market value. Closed-ended funds trade similarly to stocks, which rely heavily on the size and level of demand in their secondary market. However, open-ended funds enjoy issuance and the redemption of shares directly through the fund manager, thereby eliminating their marketability risk.

Professional Management: Investors who lack adequate financial knowledge or the time to curate and monitor an investment portfolio would stand to benefit from the expertise and experience of a team of dedicated professionals managing the funds.

What are the risks involved in investing in mutual funds?

Market Risk: Also known as unsystematic risk, this risk is exists in all asset classes and cannot be eliminated due to the fluctuations in price as a result of market forces.

FX Risk: Due to the diversification of underlying assets across different geographical locations, any funds with holdings in assets domiciled overseas or denominated in a foreign currency will inevitably face the risk of the investment value falling as a result of changes in exchange rates.

Counter-Party Risk: This risk refers to the possibility of the other party defaulting on its contractual obligations. Funds with underlying assets in debt instruments or derivatives/structured products are usually most sensitive to this risk. As such, it is strongly recommended for potential investors to exercise prudence and evaluate the counter-parties to these underlying assets accordingly. Credit ratings may be used to assist these evaluations and risk can be further managed using hedging strategies.

Political Risk: Political risk refers to the risk that political changes and instability would cause a fall in the market value of assets domiciled within the country.

Interest Rate Risk: Investors in funds that have holdings in debt instruments as their underlying assets will see the value of their investments drop when interest rates rise.

Liquidity Risk: This refers to the risk that fund managers will not be able to liquidate sufficient underlying assets to compensate for redemption requests by investors. This risk is usually prevalent in exotic funds due to the limited secondary markets for the underlying assets. In such cases, regulations usually dictate a higher cash reserve level to hedge against unexpected levels of shares redemption.

How do I start investing in mutual funds?

In Singapore, it is uncommon for fund managers to offer funds directly to retail investors due to strict regulations to protect investors. As such, mutual funds are only available through the following distributors:

CPFIS: As part of the CPF Retirement Scheme, the CPF Investment Scheme allows Singaporeans to potentially yield higher returns on their monthly contributions, to ease their retirement planning. The main asset classes available include: fixed income, ETFs, mutual funds and insurance policies. Moreover, CPFIS is only available to Singaporeans with a minimal balance of $20,000 and $40,000 in their Ordinary and Retirement accounts respectively.

Financial Advisors: Presently in the market, only a handful of financial advisors are equipped to distribute mutual funds to investors. Please consult your financial consultant for more details.

Online Platforms: With the emergence of the FinTech era, various online platforms have recently surfaced to provide retail investors with a lower-cost option to invest. Robo-advisors (e.g. DBS digi-Portfolio) and online discount brokerages (e.g. FSMOne) are prominent examples of this push towards high tech investing options, allowing retail investors to access and monitor investments at their fingertips.

Banks/Brokerages: Traditionally the main distributors of mutual funds.

Stay tuned! Till next time …

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