Funds

Most investors neither have the time, nor the experience, nor the inclination, to actively manage their investments on a day-to-day basis. Although researching the stock market and selecting stocks to buy and sell can be a rewarding process, many prefer to leave it to the professionals and invest in the stock market or other assets by investing in funds.

Funds are pooled investments, where many investors place money to be managed by qualified fund managers. All these individual and smaller amounts of money are added together and then invested. This reduces dealing and execution costs to individuals, as the costs are spread amongst all investors in the fund.

There are several different types of funds, and within these types they could be specialised or general. Specialised funds may invest in a single market sector (e.g. corporate bond funds) or asset class (e.g. equity funds). Generalised funds may invest more broadly. They can also be active, where managers invest in a range of single shares, for example, or passive, where managers invest in index tracker funds, perhaps.

Here we look at three types of funds: Unit Trusts, OEICs, and Investment Trusts.

Unit Trusts and Open Ended Investment Companies (OEICs)

These funds operate similarly, and it has become common practice for unit trusts to convert to OEICs.

The size of such funds is not limited. As new investment money comes into the fund, new units are formed and underlying assets bought to satisfy the new units created. If investors start to sell in numbers, that is ‘redeeming’ their units, the fund will have to sell some of its investments and cancel units.

Investors are often charged to make an investment, and this can be as high as 5% or 6%. This initial charge is high because commission is paid to the financial advisor that has recommended the fund to the investor. However, if the investor invests through a fund supermarket or discount broker, then this charge could be as low as zero.

Through the lifetime of the investment, management charges will be levied, and these are paid by cancellation of units. These charges can be from 0.5% for index tracker funds to as high as 2.5%. These management charges include transaction fees, audit fees, and annual management fees, and are payable whether or not the fund makes profits on its investments.

Prices for unit trusts and OEICs are calculated once per day, and this is the price at which all requested trades are executed. There will be a cut-off time for orders to be given to the fund manager for execution (so that he can amalgamate and net off buys and sells), which means that some orders won’t be executed until the following dealing day.

Unit trusts operate on a bid and offer price: that is the price at which you sell and buy units are different, and includes the initial charge. When there is higher demand for units (more buyers than sellers) the price will be quoted on a ‘bid’ basis – the bid will be the at the actual value of the units – and if there are more seller than buyers the price will be quoted on an ‘offer’ basis – the offer will be at the actual value of the underlying units.

OEICs are priced differently, with just a single price quoted. Any initial charge is levied separately.

Investment Trusts

Investment trusts are companies, whose shares are quoted on a stock exchange. Shares are issued to raise money, and then that money is used to invest. Whereas some companies might manufacture white goods, others sell ban king services, etc. investment trusts make money by investing in the shares of other companies.

Because they are like a ‘normal’ company, they can borrow money or issue new shares to raise money in order to invest.

They have a set number of shares in existence, and, unlike OEICs and unit trusts, can’t create new shares to satisfy investor demand. The price of investment trust shares will fluctuate with supply and demand. When more investors want to buy the shares, then the share price will rise. However, unlike the shares of other publicly quoted companies, such as car manufacturers, for example, the real value of investment trust shares can be calculated exactly at any moment in time. Simply adding up the value of all an investment fund’s holdings, and then dividing by the number of shares of the investment trust gives the Net Asset Value (NAV) per share.

Investment trusts tend to trade at a discount to their NAV. The implied risk to an investor is less the bigger this discount is. Most investment trusts calculate their NAVs on a daily basis, and the size of the discount to the NAV is an indicator of how popular the investment trust is amongst investors. Some investors use the NAV of an investment trust as a basis for an investment decision.

Buying the shares of an investment trust does not incur the charges that buying units in an OEIC or units trust does. But there will be a spread between the buying and selling prices, and also broker’s commission to pay as well as stamp duty on the purchase value. Annual management fees are payable by the investment trust, though this is usually offset by income received on its investments.

In conclusion

Unit trusts, OEICs, and investment trusts are pooled investments that allow investors to invest in assets selected by professional managers. There are thousands of such funds available, to suit all needs, goals, and attitudes to risk. Through such pooled investments it is easy for an individual to invest not just in different asset classes, but also in different geographies. However, care should be taken in selecting which investment fund is best for individual requirements and also it should be remembered that internal fund costs will affect performance.

Mutual Funds vs ETFs

In this article, we will try to identify the difference between mutual funds and exchange traded funds. It is widely said that an ETF behaves like a mutual fund, but can be traded like a stock. If an ETF behaves like a mutual fund, are there really any differences or similarities between ETFs and mutual funds? This article explains.

Similarities

There are some areas of similarity between ETFs and mutual funds. These can be summarised as follows:

a)    Transaction Costs

In terms of transaction costs, ETFs and mutual funds provide some of the cheapest ways of transacting in the financial markets. Transaction costs for these two assets are lower than if the trader were to be investing in the traditional stock, commodities or forex markets.

b)    Assets Traded

ETFs and mutual funds both provide avenues for investors who want to invest in multiple securities or assets from one investment vehicle. This can be achieved with exchange traded funds as well as mutual funds.

c)     Retirement Investing

Leveraged ETFs can be used for retirement investing as this ETF type employs less volatile assets as the majority constituent of its asset basket. Mutual funds are also suitable for retirement investing as they are by their very nature, required to invest in less volatile assets that produce steadier returns.

Differences

Even though ETFs are similar to mutual funds in a few ways, there are also some differences in the mechanics of both investment vehicles. Some of these differences are subtle, while other differences are quite huge.

a)    Mechanism of Trading

This is where a big gulf exists between the two. ETFs are traded like stocks, meaning that they can be traded by either taking a long position or by short selling them. In addition, ETFs are traded in such a way that they mirror the performance of the basket of securities that they are trading and not in an attempt to outperform them. Mutual funds, especially actively managed mutual funds, are managed in such a way as to outperform the indexes that they are tracking.

Another difference between ETFs and mutual funds in terms of mechanics of trading has to do with pricing. ETFs can be bought and sold at the prevailing market prices, or at a different price than the market price using pending orders, just the way a stock is bought and sold. Mutual funds can only be purchased at the closing price of the day. So this means that ETF traders have more flexibility in terms of pricing, as they can take advantage of the intraday price movements of the ETF they are purchasing or short selling to get them at prices that they find cheaper to their portfolio. A mutual fund trader does not have such privileges. Even if the price of the mutual fund asset assumes a cheaper dimension during the day, that trader must wait for the day’s trading to close before he can purchase at closing price.

b)    Taxation

Mutual fund investors are expected to pay capital gains tax on their investment. This is usually as a result of the system of rebalancing of portfolios with mutual funds. ETF portfolios are rebalanced in a different way. When adjusting the weight of the components of the ETF, no sale of the security actually occurs, so there is nothing to tax. This is not to say that when the ETF is sold, the trader does not pay capital gains tax. What we are saying here is that there are fewer taxable occurrences with an ETF portfolio than there are with a mutual fund portfolio, so ETF investors get to pay less tax than mutual fund investors.

c)     Trade Process

Since ETFs are contract-for-difference instruments, traders are allowed to buy any number of units that they want, in conformity with the leverage and margin requirements of the ETF account. Mutual fund investors have to buy preset minimums as stipulated by their fund providers.

d)    Transparency of Reporting

Mutual funds are only obligated to report their facts and figures as pertains to their business every quarter, or 4 times in a year. In contrast, ETF brokers are required to make daily reports of the transactions that have occurred on their accounts. This provides better transparency of reporting for ETFs than mutual funds, and enables traders take decisions faster on what to do with their portfolios and what adjustments need to be made.

e)    Investment Profile

Mutual funds are by the nature of their design, intended to be less speculative instruments. ETFs are CFDs, traded daily on the exchanges and have a more risky profile because of the potential for speculation.

ETFs and mutual funds provide excellent methods of investing in the financial markets, but a trader has to weigh his personal circumstances against the inherent nature of these two investment vehicles to decide which will serve him better. By understanding the similarities and differences between ETFs and mutual funds, traders will better understand how to do this.