Mutual funds (i.e. investment funds) are organisations that pull money from clients to purchased securities.
Mutual funds will usually make two types of fees on a client's invested assets; a maintenance fee and a performance fee.
Mutual assets have advantages: Experienced researchers, reduced transaction costs, and access to investment opportunities not otherwise available.
Mutual funds also have disadvantages: Mutual funds on average do not outperform the market, survivor bias is played heavily with when marketing mutual funds and costs for placing funds into a mutual fund can be very expensive.
Do your research on mutual funds before investing into them. There is no such thing as a free lunch.
Introduction
Mutual funds (i.e. investment funds) are organisations that pull money from clients to purchased securities. The service that mutual funds provide has lead to mutual funds in Australia holding ~USD$5.5 trillion dollars of assets, and making up the sixth largest foreign exchange market, with USD$121 traded daily as of April 2017. This blog will be addressing an overview of mutual funds, the advantages that mutual funds have and the disadvantages mutual funds have.
Overview of a mutual fund
Mutual funds are designed for people who wish for someone else to invest their money for them. Mutual funds can either be public or private companies, but most small to medium sized mutual funds are private companies.
A client who may invest in a mutual fund, would be someone who wants to invest their money into assets, but does not or cannot do their own research to find the best investments. Instead of the client doing it themselves, they can give their money to a mutual fund, where they do the research on different assets and invest the customer's money accordingly.
Mutual funds usually have one or both costs that they ask investors to pay; the flat fee and the performance fee.
The flat fee is often celled the management fee. This is the fee the fund takes out of the money that they are given by the client to cover the expenses of the firm's operations. This is not tied to the performance of the fund, because the organisation will still need to keep running even during a recession, and is usually a percentage of the funds that the client has invested in. Depending on the fund, this fee can be taken from the size of the client's fund at the start of the year, end of the year or an average between both.
The performance fee is the cut of the profit that the organisation takes out of a client's investment that has made a profit.
-- For example, if you invested $1,000 over 12 months and the mutual fund earns $500, the mutual fund would take a portion of that $500 as a fee (eg. 10% = $50) and you would get the rest of the profit (eg. $1,000 + $500 - $50 = $1,450).
Note: Some mutual funds will impose the maintenance fee after taking out the performance fee, so they can increase the fees that they are charging. So makes sure you look at how they do the fees first.
Advantages of mutual fund
Mutual funds will undertake research and analysis on stocks, and may have their own ratings according to what they believe should be done with the stock (eg. buy, hold or sell).
Allow for clients to invest in a wide variety of investments that they may not know about or be able to participate in if not with a mutual fund.
Mutual funds can employ rigorous methodologies for selecting investment that will grow and make a profit on a client's investment. This may be coupled with experienced researchers or people that are involved in certain industries (eg. a specialist researcher of mining stocks who used to work at a mining company).
Often mutual funds will be ranked in independent websites on their methodology for selecting investments, their fees and their past performance. This keeps them accountable to the methodology they impose when choosing assets.
Given the size of client's funds some of these mutual funds have, this huge amount can allow for them to utilize economies of scale when purchasing assets for clients.
-- For example, if ten clients did their own transactions, the costs of moving funds would quickly add up, whereas if a mutual fund purchased the assets for all ten clients, the transaction fee would be considerably less in comparison (i.e. the cost of one person doing it, when you are doing it for ten people).
Disadvantages of mutual funds
Mutual funds have not proven, on average, to outperform the market. From 2003 to 2013, most mutual funds have under perform the market, with only 42% of all large growth funds surviving in the United States in this time period.
Some more middle-low tier funds will not present their methodology for purchasing stocks. The lack of transparency means they could be making an ill informed decision with a clients assets when investing. This is why it is important to look at a mutual funds methodology before investing into them.
Survivor bias is used by mutual funds to show exaggerated performance. This can give an unrealistic return value on the funds the managed fund has invested.
-- For example, a mutual fund may either remove poor performing funds or integrate these poor performing funds onto better performing funds. Then they can state a higher return on their funds because the poor performing funds were removed and only the moderate and well performing funds remain.
Marketing for mutual funds can be deceptive. Lists and advertising for the "Top 50 Mutual Funds" usually promotes the funds that have survived, but does not mention the mutual funds that have not survived or the average return on mutual funds. A majority of these mutual funds have under performed the market or failed completely. DOW Publishing Company found, when looking at the industry in 2007, mutual funds tend to under perform the market on average, and this was worse when survivor bias is taken into account.
Maintenance and performance fees can be extremely high depending on the mutual fund (eg. some mutual funds will charge 20% on profits).
In summary, one should always do their research when investing a potential asset, this should also include researching the people who say they will make money for you. There is no such thing as a free lunch.
Barrett, A, Brodeski, B 2006, 'Survivors bias and improper measurement: How the mututal fund industry inflates actively managed fund performance', Zero Alpha Group, retrieved 6 July 2017, www.etf.com/docs/sbiasstudy.pdf.
