Mutual funds or managed funds are sometimes referred, is an essential investment tool used by investors. Mutual funds have many distinct advantages including:
1. Holding diversified portfolio of companies — this ranges from 20 to over 100 companies
2. Choice, you can choose based on the investment style, asset type or geography
3. Managed by professionals, these are full-time investors who invest and manage your portfolio
4. Supported by analysts — the fund managers are also supported by the analysts
5. Access to deals for institutions only — one interesting advantage is fund managers often have choice to access to deals that are not open to retail investors
6. Able to accumulate over long term — many funds have regular savings feature, which allows you make regular contributions from as little as $50 per month, this is an excellent way to make passive investments over long term
Because of these unique features, mutual funds are highly popular amongst investors, most investors are simply too busy with their work or daily life, and very few have the time and energy to spend full time managing their investments — this is when mutual funds are the excellent choice.
However, there are thousands of mutual funds out there and many of them have similar portfolio, how do you choose them, and how do you know which ones will be the most suitable ones for you?
We have compiled the 10 Golden Rules:
Rule 1: Active or Passive Investments
This is the very first step — as you can choose between active and passive funds. Active fund managers seek ways to outperform the index, but this often also means more risk approach. For instance, they may hold emerging companies, they may invest in emerging markets, they may use derivatives to maximize the performance. The passive investors, on the other hand, tend to follow the index, and often adopt the index fund strategy or invest in large companies.
Rule 2: Long Term or Short Term
Most investors who choose mutual funds are long-term investors. However, there are also many short-term investors. They choose funds that can best perform at the time, and switch them to other funds when the economy cycle changes. For example, many investors concentrate their investments in the mining sector at moment, and some of them are switching from mining sector into real estate and technology sectors as they believe they are the next industries to boom.
Rule 3: Do you have an existing portfolio
Most of us own shares one way or another. Pension funds is the most common way investors accumulate their wealth, and you may also have funds for college funds or have shares under your name. One risk is over-concentrating your investment, you may end up investing in mutual funds that you already have.
Before you start investing in your mutual funds, look at what you have first before you make your final decision.
Rule 4: Diversify your mutual fund portfolio
Diversification is really what mutual funds is all about. You should diversify in multiple ways. You should diversify them based on the asset (eg. Buy into bond funds), diversify into regions (eg. Asia Pacific) or diversify by strategy (eg. Invest into long & short or emerging companies funds).
Rule 5: Understand liquidity and flexibility
A big problem occurred during GFC was freeze of capital. This had resulted in freeze of many mutual funds; as well as suspension of dividends and distributions. This had caused a lot of issues to investors especially for retirees who rely on income from these investments.
Liquidity can be a real risk for mutual funds during financial crisis as the fund managers have discretionary choice to temporarily suspend the redemption. In order to avoid these issues, diversification is again a major strategy.
Liquidity issues usually occur when the fund manager is unable to sell their underlying holdings due to lack of liquidity in the market. Large funds such as index funds usually do not have these problems as they invest in highly traded shares.
Smaller funds, or those investing in corporate bonds or emerging companies are the ones that are likely to face liquidity risk the most.
Rule 6: How much fees are you paying?
The fee structure for each fund is different. For the basic, you will be looking at an annual management fee, typically this is quite small for index funds, but higher for more active managed funds especially if they are investing in emerging markets or emerging companies.
Some funds also charge application fees which can add to another 4% of fees, this is usually once-off charge.
Investors also need to understand the manager incentive structure — some fund managers have discretionary policy which they can decide how much bonus the manager receives.
The tricky part is to understand the benchmark they use, I have seen international fund managers using local index as their benchmark, which is not really appropriate. The fund managers reward themselves bonus even when the fund has produced a negative return; this is the type of fund I tend to avoid.
Rule 7: Look for alternative and choices
There are so many choices; you do need to stick to one or two fund managers. In addition, you can also consider Exchange Traded Funds (ETFs). For example, if you are investing in index funds, then there is not much difference between buying into an Index Mutual Fund or an index ETF.
If you do not like a particular fund manager, then switch to someone else. It is a very competitive industry and investors do switch frequently.
Another important is looking at funds overseas. I was looking for a mutual fund that invests in China, I could only find a handful of specialists here, so I went to Hong Kong and US, and there were much more choices to select from.
Rule 8: How do you make regular savings?
I still believe mutual funds are the best ways to make long-term savings. Pick several funds and start your savings plan. As an example, I have 2 dividend producing funds for my retirement, and 2 growth funds for my children’s education funds.
Some funds actually charge fees for regular savings, which should be waived as they can add to a significant cost over the long term.
Rule 9: Do you want to trade your mutual funds?
This is where Exchange Traded Funds becomes very handy. If you are treating funds like shares, then you should consider ETFs. ETFs move up and down everyday just like shares, and sometimes this can be quite volatile which provides good platform for regular traders.
Mutual funds are not really designed for trading as the investing and redemption period is much longer, you can’t make an instant transaction as in the case of ETF.
Rule 10: Understand your fund manager
The biggest risk for mutual fund is the fund manager. A fund performs when a good fund manager is in place, and suffers when he / she leaves. There is another interesting way to analyze your fund manager, many boutique funds were set up by fund managers themselves, and they are often the largest shareholder in these funds.
In another word, their investments is tied with their performance, for these funds, they have more initiatives to perform than others — these can be some of the best performing funds as the result.