Diversification is a vial strategy that limits risk. Essentially we spread our investments around by buying shares in different companies and investing in different asset classes. For more information on diversification please read our diversification guide.
By spreading your investment across various types of assets, you lessen the risk that one bad investment will significantly reduce the overall value of your stock portfolio. The only problem with diversification is that the average investor does not usually have enough funds to diversify properly – especially someone who is just starting out. So what is the solution? The easiest way is to invest in financial instruments that will allow investors to pool their money together with other investors into a single fund that then is able to invest in other companies and asset classes that is otherwise out of reach of a single person.
These investment vehicles include managed funds, index funds & exchange traded funds (ETF). In this article we will concentrate on managed funds (active managed funds).
How managed funds work?
Managed funds, also known as unit trust or mutual funds, allow investors to pool their money together and buy different companies and in a variety of asset classes. The fund is managed by a team of professional fund managers. Similar to shares in a company, you buy units in a managed fund that are all equally valued. If the assets held by the fund go up, the unit price also rises. When the fund makes a profit by selling assets in the fund, or if the assets in the fund generate income, it will be passed on to fund holders in the form of 'distributions'.
The value of each unit in the fund is determined by the Net Asset Value (NAV), which is the total asset of fund (minus costs, fees). The NAV is typically calculated on a per share basis.
For example:
Let's say investors collectively provide $1 million to a fund manager to invest. The fund manager will issue 1 million units each at $1. If you invested $5,000, you will receive 5,000 units in the fund. Let’s say after 5 years the fund turns the original $1million into $2million (after fees and costs). So the Net Asset Value is now $2million, or $2 per unit. In another words your $1 per unit has doubled to $2 per unit which in effect has doubled your initial investment of $5,000 to $10,000.
The advantages & disadvantages of Managed Funds
Advantages
Professional Management
Managed funds are managed by a professional fund management team. These managers have access to research and resources that most individual investors do not. They are experts on the economic climate and how it can effect your investments. Fund managers will help research, select and monitor your investments.
Diversification
If you were to invest $1,000 into direct shares, you wouldn't be able to do much in terms of diversification. However, if you purchased units in a managed fund (Australian share fund for example) then your $1,000 will be invested across hundreds of Australian companies, giving you the diversification that is required. Without doubt this is the strongest attribute of the managed fund.
Affordable
One reason why managed funds are so popular in Australia is that you don't need thousands of dollars to get started (over 1.3 trillion have been invested in managed funds by March 2006). You can buy into most managed funds for as little as $1,000. Many funds will then allow you to go on a savings plan where by you can add an additional $100 into the fund at a time without incurring any fees (unlike shares where you need to pay brokerage fees).
Also, the fact that monies are pooled together to create a larger fund, the commission costs of buying and selling individual shares are greatly diluted. For example let’s say you had only $5,000 to invest and you buy 20 different stocks yourself, if we assume each trade is $30 then commission alone is $600 or 12% of your investment!
Choices
With over 6,000 funds to choose from you are bound to find the funds that will meet your investment objective goals. Managed funds can invest in shares, property, bonds and/or the money markets.
Liquidity
Like shares, managed funds are liquid assets; this means that if you want, you may redeem parts or all of your share/units on any business day (restrictions may apply). Unlike shares though, you don't need to pair up a buyer and seller in order to establish a buy/sell transaction.
Disadvantages
Fees
Probably the biggest drawback with managed funds is the fees involved. These fees usually eat into the returns of the fund and is the main reason why many funds return sub par performances. Many investors would agree that if the fund is generating 20%+ returns then the fees are fair, however you need to pay these fees whether or not the funds make a gain. That's right; you could be paying 2.5% of your investment even if the fund generates a 10% loss.
The 2 main fees involved with managed funds are the Entry and Exit fee, and the ongoing fee or the MER (Management Expense Ratio). The entry and exit fee is typically 4% although this amount can usually be waived if you invest via an online discount broker.
The MER or the Management Expense Ratio (MER) is the ongoing fee that you need to pay the fund manager for managing the fund. This is a ratio of your entire investment, so the more money you have in the fund the higher the fee. The typical MER is about 2% of your investment. The MER for passive funds (i.e. index funds) are considerably lower, usually between 0.3-1%
Lack of control
Unlike shares you cannot select the individual stock. Once the fund is chosen you must place your trust in the management team.
What fund should I choose?
There are over 6,000 managed funds on the market today all investing in different sectors and asset classes. There are 6 main types of asset-specific funds, they are, share funds, property funds, hedge funds, fixed interest funds, mortgage funds, cash funds and multi-sector funds. So with all thousands of funds out there which one should you choose?
Most online discount brokers will have search facilities to help you shortlist the thousands of funds available based on criteria that you set. In addition there are research houses such as Morningstar that rates individual funds (5 star rating system). Although helpful, investors should be aware that these ratings shouldn't be the only reason why you choose a specific fund as they are not always 100% reliable.
For more details on Morningstar, visit http://www.morningstar.com.au/
Managed funds should be selected in a similar way you choose any other investments; it depends on your level of risk appetite, time horizon and goals.
Tips & Tricks
- Before investing in any fund it is important that you obtain as much information as possible about the fund. One of the common traps for investors is thinking that the best managed funds for one year will be the best for the next. In most cases this is not the case. You will get a better look at the fund if you view the performance based on the life of the fund. How did it perform during both bad and good times? It is important to remember that past performances does not necessary mean you will get the same results in the future.
- If you are new to investing in managed funds, it is probably a good idea to choose a fund that is run by a more established fund manager.
- An entry fee of 4% is usually charged if you invest in a managed fund through a financial planner, however many online discount brokers will cut this fee to 0% by way of rebates.
- Read the funds prospectus carefully.
What is the best managed fund? The top managed fund?
There really is not such thing as the best or the top managed funds, however below are some of the largest managed funds based on fund size (As of 2011):
- Platinum International Fund - Fund size: AUD$7,830 million
- Vanguard Australian Fixed Interest Index Fund:AUD $1,734.57 million
- Colonial First State Imputational Fund: Fund size: AUD$1,712.7 million
- Perpetual Industrial share fund:AUD $1,560 million
- Credit Suisse International fund/Aberdeen Asset Management
- UBS Australian Share Fund: AUD$985.54 million
Other fund managers worth mentioning are MLC managed funds, Macquarie managed funds, Westpac managed funds and BT managed funds
Remember to do your research carefully and select a managed fund that will fit you objectives and your risk appetite because at the end of the day it’s your money.