As a personal investor, your mutual funds are your life-blood. Their ability to place a smaller retail client in a favourable buying position, combined with the benefits of professional management out-weigh any other asset class in your portfolio. Be they income producing or speculative, your ability to work together with your advisor to balance a portfolio of mutual funds differentiates you as a sophisticated investor. With that in mind, I’d like to take this opportunity to present another multi-part series expanding on the tutorial section’s discussion of Mutual Funds.
By the end of this progression, you’ll be aware of exactly how it is you’re benefitting from your Mutual Funds, where the opportunities are for you to further benefit, and where the little-known risks are hiding behind the scenes. Lastly, I’ll dig into how you can actively manage specific fund categories to maximize your benefit throughout the progression of the economic cycle. With all that in mind then, let’s start with the good stuff: How do we realize a return from a Mutual Fund in the real world?
Mutual Funds will generate returns for investors in one of two ways: the fund’s NAV can grow, and therefore improve the redemption amount that the investor will receive, or the fund may choose to distribute its returns to investors at regular or irregular intervals. Regardless of the venue, or taxation system in place, it is important to understand that the returns of a mutual fund all come down to its NAV. As the value of assets held by a fund increase in value, the investor benefits. This results in the creation of two major categorizations of funds: Active and Passive.
An active fund is more expensive than a passive fund, but is managed by a professional to adjust the asset allocation within the portfolio, and to ensure that the unit holders are never over-exposed beyond the level of risk outlined in the prospectus. This level of risk management can take a variety of forms, ranging from simple portfolio re-balancing and income distributions, to a legislated amount of derivatives usage.
While, a personal investment advisor can arguably help you to balance your own portfolio regularly, it is important to note how the returns of fixed-income investments (specifically those related to bonds) tend to provide extremely favourable returns to investors, in that the bonds included are much more conducive to a level of diversification that a small personal investor may not be able to afford.
This means that you get access to the higher income levels from a bond-portfolio, which is marginally less risky than what you would likely be able to build with the resources you and your advisor currently have on hand. Products from companies like Templeton have shown a great propensity for this sort of investment over the recent decade. (Note: you know the rules guys, past performance is not an indicator of future results. You should consult your investment advisor before even looking at any investments, even if it is provided by an established Fund provider).
Passive funds are becoming increasingly popular as the modern personal investor becomes more sophisticated. As retail clients manage more of their accounts independently through a discount broker, they are trending to focus less on specific complex solutions that they’ve engineered themselves, and instead focus on broad macro-strategies. Specifically, asset allocation strategies have become particularly relevant as of late. By following economic trends, a reasonably informed investor can arguably outperform the market by cycling their exposure to favour those sectors that historically perform the best within a given economic period.
For example, defensive stocks and long-term bonds have been known to be favourable investments during periods of economic contraction due to their tendency towards highly predictable yield. An investor that pursues a more dynamic portfolio would proceed to purchase units in a mutual fund that passively tracks the returns of these types of equities for as long as they believe the contraction will occur, and would then proceed to cycle their portfolio into the next relevant asset class (likely being short-term bonds and cyclical equities, depending on their time horizon). Such is the benefit of passive funds. They are extremely inexpensive, and allow the investor to take on diversified exposure to broad market trends on their own terms.
Sounds easy right? Well, the upside opportunities are clear as day when dealing with funds. It’s the downside where things become tricky. In the next posting, I’ll show you just how elaborate the down-side risks of Mutual Funds can be, and what you need to be aware of when dealing with them.
Next: Part 2 Practical Mutual Funds: Risks Involved With Mutual Funds
