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Mutual Funds |
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The principal characteristics • Choosing the right fund • The choosing criteria • The construction of an efficient portfolio of mutual funds
The mutual funds are a common and a collective box where the savings of a plurality of private investors is invested in movable values (state funds, foreign bonds, shares, and so on) by firms affiliated to a special Bulletin-board. The principal purpose of a mutual fund is that to get, through a collective management, advantages in terms of yields, lower costs, greater contractual power in the investment and in the diversification of the portfolio. The fund doesn't guarantee any outcome however: the return for the underwriter depends above all on the activities in which is invested. Therefore, a fund based on European bonds will have an output in line with that of the government funds of the European Countries, one based on foreign shares with that of the foreign Exchanges, etc. The portfolio of a mutual fund is the one of the underwriters that participate in it and it is separated in quotas. Technically the saver purchases some quotas of the same fund, whose value daily appears on the press and on the other media.
The patrimony of the fund is managed altogether (unlike the property managements, where every client is owner of well identified titles) and divided into quotas. In the mutual fund the underwriter is therefore owner of part of the patrimony - equal in substance to the payment effected more or less the capital gain capitalized by the manager – and not of that title in which the patrimony of the same fund is invested into. The value of a quota, daily updated (and in this relies the transparency of the product that allows to verify with continuity the course of the investment) is anything else other than the market value of the employments of the fund - after expenses and management fees - divided by the number of quotas issued at that time. The resources poured by the underwriters of the fund constitute a patrimony separated by that of the management brokers: the latter are checked by banks and by insurance companies as to satisfy the requisites of solidity. It is in every important to know the stock structure of the management brokers to appraise their reliability. The mutual funds could be either open or closed. If open, the entry of the new underwriters is free and it is allowed in any moment to reenter in possession of the own investment which is liquidated by the management brokers in base of the value of the quota. The patrimony of the mutual funds, therefore, is not fixed because it can increase or decrease in relation to the flows. If the signatures overcome the payoffs, the patrimony records an increase, in the opposite it suffers a diminution. The titles that belong to the patrimony of the fund are guaranteed by a depositary bank that looks over the real existence of the values. The management brokers societies are subject to the double vigilance of Stock Exchanges Committees and National Banks. All of this has had the consequence that, in their particularly short history (they have started in 1984), the mutual funds have reached a patrimony of over 500 billion of Euros without recording any case of insolvency. The funds are also disciplined severely under the organizational profile of the subjects that manage them and under also the profile of the portfolio diversification.
The costs They are represented by the entry fees (if present) to be charged on the underwriters and by those of management (always present), charged directly on the fund. Some fund also introduces fees of reimbursement (as to charge the underwriters) and many incentive fees (charged on the patrimony of the fund), applied when the returns of the fund overcome a certain threshold. The value of the quota is usually before taxes and management and incentive fees. If a fund is more expensive that could be caused by a greater value added to the management. This is due because the costs make more difficulty the manager's job, in which they “lift” the output attended that has to produce for getting superior performance in comparison to the benchmark.
The buying process That could happen in two ways: the investment in one only solution, the so-called Pic, or with multiple periodic investments. The latter, called also plan of capital accumulation or Pac, represents the more popular form of investment because the families save usually month after month, year after year. The Pacs are formidable tools for the financial planning of the family: they allow in fact to accumulate and to grow the savings month after month, year after year in automatic way. And they allow also at the same time to buy more quotas of the fund when their price is low and less quotas when their price is high.
The duration The duration is the weighted average of the expirations of the present value flows offered by a fund. Practically, the actual value of every flow is calculated is discounted to the rate of return of the fund, and then such values are multiplied by the number of days to expiration. The nearest coupons in time will have a greater actual value and therefore a greater weight of those more distant so that the capital to expiration will have a much smaller actual value. The weighted average of such flows, or the duration, will be less than the residual life of the title.
There are various types of mutual funds on the market with different characteristics in terms of the expected risk/yield. There are monetary funds that invest especially in sghort term bond tools, bond funds that invest in middle-long term bonds tools, domestic stock funds that invest especially in stock shares of national market, international stock funds that diversify the investment into foreign countries. The characteristics of the investor are therefore remarkable in the moment in which he chooses the category of mutual funds in which invest. An individual that is forced to sell the quota of a mutual fund after a few months because of a possible short of liquidity, he will do better to invest in a fund of liquidity, while an individual with a long temporal horizon and a level of wealth satisfactory can decide to invest in an international stock fund.
Monetary funds They cannot invest in shares and they destine all the money to bonds and liquidity. The funds of liquidity cannot invest in tools without a rating and the financial tools in the portfolio have to have a rating not less than A2 (Moody's) or A (S&P). The maximum duration of the portfolio is 6 months and the coverage of the risk of change is not admitted. The monetary funds are differentiated in four categories on the base of the title currency of issue in the portfolio: European area, area dollar, area yen, area other currencies. The European monetary funds invest in tools of the monetary market. They are tools therefore proper for whom cannot invest in the long period, even if it has an imminent expense to face. Their output is in line with that of the government bonds. As a consequence it is not elevated, but at the same time it is stable because the value of the quota rarely oscillates. The probability that the investment closes in loss since the moment of the subscription is particularly low.
Bond funds They cannot invest in shares (with the exception of the mixed bond that can invest up to 20% in the Exchange Markets) and therefore they destine all the portfolio to bonds and liquidity. They tend to satisfy the demand of whom want to make to grow the capital in the middle period (3-5 years). On these temporal horizons, their final output is usually greater than that of the monetary funds but the oscillation of the quota (volatility) is grater. The volatility of the bonds is greater when more the average of the expiration of the coupons in the portfolio is high (duration) and when it’s also greater the exposure to the monetary risk. Keep in mind that the exposure to the monetary risk not only depends on the percentage of titles in currency present in the portfolio, but also on the fact that these titles are covered by the exchange rate risk, modeled with techniques ad-hoc (currency swap and so on), which use depends on the strategies of the manager. The classification of the specialized bond funds is based on two criterions: market risk (currency of the portfolio has duration of 2) and credit risk or jurisdiction of the drawer (developed Countries rather than emergent), the drawer's typology (sovereign rather than undertaken), investment grade rather than highyield. Their portfolio consist in an investment that mainly covers at least 70% (or 80%) of the portfolio and a residual investment equal to the 30% (or 20%) maximum represented by bond tools with rating non inferior to Baa3 (Moody's) or BBB - (S&P), and denominated in Euro currencies (European funds), in US dollar (dollar funds), in yen (yen funds), or whatever currency (other funds).
Balanced funds They invest in a mix of government funds, funds and shares, inside the country and into the foreign countries with only one constraint: the quota of the portfolio destined to the shares has to be between 10 and 90%. They are perfect to whom want to grow the capital in the middle-long period (over 5 years), with a grater potential output to that of the bonds but with a greater volatility because of the stock component. They are separated in 3 categories: balanced bonds, balanced and balanced stock according to the weight of the shares in portfolio (respectively: 10-50%, 30-70% and 50-90%).
Stock funds They primarily invest (at least the 70% of the portfolio) in shares and they are proper as to satisfy the demand of whom wants to grow the capital in the long period (7-10 years and over). The risk factor of the share funds increases in general with some specialization. The funds diversified on more Countries are generally those less volatile. The stock funds are separated in 18 categories, characterized by a main investment of at least the 70% of the portfolio with specializations defined by the categories and by a residual investment equal to the maximum of the 30% of the portfolio in bonds or in liquidity in the currency of the market of reference.
Flexible funds They cannot be classified in any of the preceding categories and they are the most speculative funds because they invest without restrictions - according to the fixed criterions by the rule - in liquidity, bonds, stock, Euros and not Euros according to the expectations of the manager. On these funds unlike all the others, there is no obligation of comparison with the benchmark.
Other categories Further type of funds concern the ethical funds, indexed, to protected capital and guaranteed capital. The first are products that propose to protect the invested capital, the seconds guarantee (with an insurance contract) the same capital to preset expirations.
The Exchange Traded Fund They are not proper mutual funds but they represent a valid alternative to the indexed common funds or, also, to active management considering that in the greatest part of the cases the latter doesn't succeed in beating the benchmark. The Etfs (Exchange traded fund) are titles representative titles of portfolios that reply particular indexes or baskets of Exchange. Every issue has the objective to synthetically produce a profile of risk/yeld corresponding to that of the underlying index. The Etfs can be negotiated in real time as if they were stocks without waiting for the moment of signature and collection. To every Etf corresponds an underlying portfolio that replies the composition of the index of reference, portfolio that is administered by a financial intermediary that acts as issuer (Société Generale, Barclays, Morgan Stanley, Merrill Lynch are the most known). The greatest part of the Etfs doesn't have expiration. They are therefore formidable tools to exploit the growth of long period of the stock markets in a simple, transparent way and with limited costs and good opportunities to sell them. They are interesting tools of investment even if they are less proper than futures and options for the speculation of brief period (futures and options can count on the effect of leverage, the indexed shares cannot).
The choice of the category is only the first footstep; the second consists in the choice of a specific mutual fund. This is also perhaps a problem more difficult than the precedent to solve especially in countries where dominates a distributive model in which the greatest part of the banks and the networks of financial promoters only sell the mutual funds of the group and not those of the competitors. So the savers generally choose the fund offered to them by their own bank. The advent of the supermarkets of the property managements in funds is slowly changing this scenery. In order to proceed to the selection of the mutual funds is necessary to make a series of considerations. The principal elements are: the cost of the investment and the past profitability of the mutual fund. The cost of the investment It varies from fund to fund, from a category to the other. Typically the most expensive funds are the ones based on stocks while the least expensive are the monetary ones. The costs of management then can be divided in predetermined and not. The predetermined are the management fees, that of entry and of exit as well as those of incentive. Among the costs not predetermined charged on the fund there are the negotiation fees, the costs for the remuneration of the depositary bank and the costs of certification. All the costs, predetermined and not are exposed however in the informative prospectus that accompanies the selling of the quotas. The general cost of a fund is calculated and synthesized by the Ter (Total expense ratio), signalled on the prospectuses. Anyway, the actual cost of the mutual funds is in their distribution, not in their management. As for the Etfs, they foresee a year management fee to be added also to the negotiation fees.
The past profitability of the mutual fund The mutual funds are the most transparent financial tools on the market: every day their market value, equal to the market value of their portfolio is communicated. Profitability is however rather difficult to interpret and to appraise. The simple indication of the past output doesn't mean a lot because generally the average output of a financial strategy is tied up to the quantity of carried risk. As a consequence, it is possible that the funds that have offered a high output are also those with riskier wallet and that the output is simply interpretable as a compensation for the carried risk. You would be therefore in need to effect an appropriate correction for the risk. Two indicators then are used to point out to this fact, the index of Sharpe and the rating.
The index of Sharpe It divides the average output offered by the fund, without the interest rate, by the standard deviation of the difference among the output of the fund and the rate without risk. This indicator compares different mutual funds under the risk point of view, dividing the output offered by the risk taken. Practically, it is given by the relationship between the greatest output and the greatest risk that a title offers in comparison to something that doesn't have a risk (case of government bonds). If the index is greater than zero, you can to say that the title which the index is referred takes some more risk in comparison to a government bund, but, in the other hand, it compensates the investor with an output more than proportional. If, instead, the index of Sharpe is negative, that means that the output is not worth the risk taken. The indicator is therefore interpretable as a measure of output for unity of risk. The application of the indicator is correct in the cases in which all the wealth of the individual has been invested in the mutual fund subject to the evaluation or in banking savings. Particularly, the indicator is not applicable when the mutual fund is held together to other risky activities within a portfolio. In such a situation the correct evaluation must have been carried out keeping in mind the impact of the fund within the global output of the portfolio.
The rating It is more and more a diffused way to appraise the funds and it consists in one classification within certain categories. The more diffused rating system in the United States is that of Morningstar, that divides the mutual funds on the base of "stars": the best funds are classified with "5 stars", those worse with only one star. The rating of Morningstar is got on the base of a very complex procedure that considers both the performance and the risk of every fund in terms related to the performance and to the risk of the belonging funds of the same category. The Nobel Prize for the economy William Sharpe has shown in 1998 that the classification of Morningstar has a high correlation with the classification performed on the base of the index set by himself. The rating has become the key factor of choice of the mutual funds in the United States, where 80% of the investment flows concern funds with 4-5 stars.
The benchmark The parameter is representative of the expected risk/yield profile for the fund and, at the end, for the markets in which the patrimony is invested. The comparison between the output of a mutual fund and that of a market index is a way to appraise the management. If we adopt as "benchmark of the benchmarks" the results gotten by the American managers - the most evolved market of the world - we discover that they are not as for quite better of those of the European colleagues’ performance in comparison to the benchmarks. Yet about ten million of American families possess quotas of mutual funds and they keep on undersigning her: from the January 1971 to October 2001 only 75 stock funds out of 171 (less than 44%) have beaten the Wilshire 5000 index, representative of the whole universe of the rated titles. In contrary, the 44% of the funds have made less than the index of at least 2 points a year. From the January 1984 to October 2001 it has gone worse: only 39 stock funds out of 276 (14%) have beaten the Wilshire 5000m index, while around half of the funds has underperformed the index of at least 2 points a year. It can be concluded that the law of the benchmark is hard to beat in Europe. Why then the managers of the whole world have a tough work to beat the indexes of market in a consistent way? Besides the taxes, the costs charged to the fund (negotiation, certification, fees in the deposit bank, and so on), to the management fees (in average a total of 2,5% a year), it is necessary to remember that the managers compete with other managers with equal or superior ability of stock picking and it is impossible that every manager beats the average. However, not all the experts are in agreement on the role of the benchmark. If, for some people it is a good parameter with which to compare the performance of the fund and to have a description of the expected risk/yield profile - for example, a fund that has a benchmark composed by 80% of the Msci World index and of 20% by government funds index will have a risk/yield profile very similar to that of a portfolio invested in a basket of the principal world stocks. According to this position, the benchmark has a fundamental role of communication to the public of the structure of the portfolio of the mutual fund useful for evaluate the attended risk more than the attended output. A superficial use of the benchmark in the evaluation of the quality of the management can result therefore misleading and conduct to wrong financial choices, also for the following reasons: - Asymmetry among the presence of costs for the financial manager and the absence in the benchmark: as we have already mentioned, the investment mutual fund suffers some costs from the active management of the portfolio, on which output the taxes are paid; the benchmark for definition is represented from an index or from a portfolio composed by various indexes in fixed proportions that is not subject to costs of some kind. Besides, while the mutual fund reinvests the dividends collected on the stocks owned, the stock benchmarks doesn’t. It is therefore inevitable that the output of the mutual fund is less than that of the benchmark unless the active management has been performed with such an ability as to produce higher outputs than the benchmark of reference for the whole amount of the necessary costs for the management. - Dynamic choices of portfolio following the constancy of the benchmark: the real portfolio of funds can vary according to the conditions of the markets, while the benchmark is for its nature a strategic portfolio that remains fixed for a period of three, five years. In this case, the benchmark serves to some people as indicative of the quality of the management in short periods. The mutual funds could try to limit the impact of this factor modifying the portfolio in the short period, or rather clarifying the rules in base to which they decide to vary the quotas of portfolio in the various assets class. This specification is very diffused in the United States where the managers often point out the most used variables for the active choice of titles: for example, the relationship between the market price of the title and the anticipated profits. In presence of this situation becomes easier to appraise the motivations at the base of the deviations between the managed portfolio and the benchmark of reference. - Statistic problems depending on the average output and its volatility: from the historical series of the outputs of one determined financial activity is possible to evaluate with a certain precision the volatility of the output while the percentage of uncertainty of the average output is particularly spread. This has important implications for the discussion related to the use of the benchmark. If in fact the historical output of a certain portfolio is a weak guide to form the expectation of the future output, it can be unwise to think that it represents the best guide on which base the expectation of the output of a mutual fund, especially if managed in the active way. On the other hand, if the risk is statistically easier to be evaluated than the average output, it can be opportune to assign to the benchmark a value of description to the portfolio structure of the mutual fund and to the connected risk for its detention in the portfolio.
The different types of management When the manager tries to outperform the benchmark modifying the weights of the portfolio according to the expectations privileging some titles in comparison to others is called of active management. On the other hand, there are funds that have indexed their output to that of the benchmarks and are therefore defined index fund or replicate funds, considering that their portfolio replies the basket of titles that is at the base of the benchmark. It is obvious that, keep constant the other conditions, a passive fund management (indexed) has to cost less than an active one. In the middle there are the enhanced fund, whose managers enjoy of a limited freedom for getting higher outputs than those of the benchmark. There are then the quantitative management funds in which the objective is still to beat the benchmarks but the process of selection of the titles and of the asset allocation is totally submitted to mathematical elaborations without an analysis "on the field". The advantage of the funds managed quantitatively is in their discipline and therefore in the total lack of psychological or emotional influences as can be found in some stock-exchange sectors, and also in their very low costs of management. In reality then, many mutual funds have a tracking error (differences of the output of the portfolio in comparison to that of the benchmark) strongly limited.
Benchmark, output and persistence The empirical results show that the evaluation of the quality of the performance is negative when the indexes of price of the various markets are used as benchmark. The academic literature has faced this problem since the '60s, in reference to the American market in which the mutual funds have a long tradition. The greatest part of the researches concludes in a univocal way: the managers of the mutual funds are able to have higher outputs than those of the benchmark but not of such a figure to compensate the costs sustained for their active management. A study appraises in around 85 basic points (0,65% a year) the difference between the outputs of the active stock funds and that of the benchmarks. A saver that has a modest amount of money cannot diversify the portfolio purchasing many titles. On the other hand, a saver that has a suitable capital would not to have the time and/or the technical competences to invest in various titles. The common funds would serve therefore to access the benefits of the diversification with a small capital and also without specific knowledge. The saver would be prepared to also suffer a loss of some fraction of percentage to access the benefits of the diversification. In order to analyze the existence of persistence it needs to divide the funds in various categories in base of the past output and to understand whether the funds belonging to the best groups during a certain period continue to belong to the good group in the following period. The results of the studies are not definitive. Some people sustain that the persistence exists and is quantitatively important. Others believe that the persistence disappears if an opportune correction is effected by the risk and the costs of formation of the various wallets are considered.
Stock picking and market timing The active management can be realizing following two methodologies of investment radically different: stock picking and market timing. In the first case the manager devotes her time in the analysis of the single shares trying to individualize those that have the greatest probability to outperform the market with the support of the fundamental analysis. In the second case, the manager tries to foresee in general the trend of the stock market using the technical analysis. Practically the managers don't rigidly choose one or the other style: the output of the funds is the result that is gotten mixing the efforts directed to choose the best titles with the attempt to foresee in general the movements of the market. It is important to know if the fund is indexed to the benchmark or if the investments depend on an active management. In the first case, in fact, it is known that the performances will be tied up to the course of a market while, acquiring a fund not indexed is bet on the abilities of the manager.
The construction of an efficient portfolio of mutual funds
The definition of the asset allocation The logical process of an investment, in funds or in any other financial tool, should be based departing from the definition of the asset allocation and subsequently in the choice of the products to realize it. Instead, the choice often happens on the base of a simple question: "How much does it make?". Reassured on this, the saver is convinced to have purchased if not the best, at least something that is near to it. But the market changes cannot permit him to confirm the attended outputs, or he has to face unexpected expenses and, therefore, he is forced to sell early. Those are all causes to change investment and make the wrong choice in the worse moment. Then which correct optic should be taken for facing the markets? Even before to wonder how much it makes a product, it needs to wonder what are the objectives to reach and, above all, the time to reach them. The definition of the objectives is not so immediate as it could appear. Basically, it means turning aspirations and generic desires into concrete and realistic results quantifying them. Such approach is valid for all the ages and for all the pockets. From the definition of the asset allocation depends in good part the future performance. The probability of realizing an asset winning allocation depends on the attitude toward the risk of the investor, on the period of the investment, on the age, on the financial availabilities and on the specific preferences. There are no miracle recipes: it doesn't exist “the good investment earning the maximum risking the least”. It cannot be known in advance which financial tool will get the best performance in the following years. Neither can be exclusively chosen on the base of the past performances. A good asset personal allocation is realized through the choice of a fund portfolio as adherent as possible to his own objectives of investment (integration of the pension, accumulation of the capital for the school of his children or to buy a house and so on), and though the analysis of the other personal characteristics (age, available patrimony, propensity to the risk, flows of incomes, available coverage on some needs). In other words, in order to invest well is much more important to know themselves rather than than the markets.
The financial planning The question to be asked is therefore "for what do I have to invest?". The choice of the investment product happens accordingly, after the identification of the need or the needs to be satisfied, in order of priority. One of the primary demands of the families is, for example, to constitute a reserve for the unforeseen events. In this case the coherent investment will have to be to low the risk. There are then the necessary expenses to finance the more important projects in one’s life as to buy a house, to instruct children and so street. The more the objective is remarkable, the smaller it is the bearable risk. But, while the time in disposal increases the level of risk that that one can reasonably bear can increase as well. In contrary, if one wants to quickly get a capital with scarce initial resources, the only possible way to do that is the investments with a high risk. The process that goes from the individualization of the necessities to the realization of their solutions is defined "financial planning of the family". The purposes of the investments make change the choices of investments themselves: the strategy that correct for paying the university to one’s children is not suitable to create an integrative pension, while the strategy to buy the first house is not proper to finance the vacations. The following are the typical objectives of the financial planning that can be reached with the tools of the managed saving.
The management of the liquidity The momentary excesses between entrances and family expenses must be invested, even in tools easily collectable as to avoid that they impoverish in real terms. The banking saving account, on which these temporary excesses can be accumulated, in fact, is not an investment but a mean of payment: the figures that remain on the account lose the purchase power. All the families should however have a reserve of liquidity (equal to 3-6 months of family entrances) to satisfy unforeseen demands like, for example, sanitary expenses. Typically, this should represent a financial priority need for any family, but at the same time the quota of liquidity in the domestic portfolio should not be too high, because this is the component that makes potentially less.
The growth of the capital In order to grow the capital for the purposes that is used (purchase of the house, children's school, inheritance and so on), the propensity to the risk and the temporal horizon of investment become important. The higher is the first, the longer is the second, more aggressive will have to be the selected tools. The rule to be respected is that of the diversification. Again, in lack of a precise purpose, it can be affirmed that any family has the least objective of growth of the capital, that is that to get from its own savings an output higher than the inflation.
The fruition of a periodic income This is a necessity that cannot only be manifested when somebody retires but in any phase of the life when the current entrances are insufficient to maintain the desired way of life. To put the philosophy of the financial planning into effect it is necessary to proceed with two operational passages: the division of the available patrimony in a portfolio of investments and the forecast of a plan of investments of the future savings. The realization of these two passages allows to satisfy the preset demands in order of priority in line with the available resources. But even before to do any financial plan, it is necessary to understand how much one is able to save. In order to do so, it can be useful to elaborate a family budget as to fix the objectives of expense and saving and to check whether they can be respected. In conclusion, the most elementary passages that the most aware families should face are: 1. to acquire full awareness of its own financial priority needs and its resources (present and future) available to achieve them; 2. to know the financial tools that allow to satisfy these needs; 3. to adopt a plan that, through the use of these tools, allows to achieve the preset objectives; 4. to stay consistent with the line defined in the plan. This last is perhaps one of the most difficult behaviors to put into effect. The oscillations of the markets, amplified by the media, can draw into the temptation to change during the realization of the plan, in the hope to correct the effects of the losses. But, far from the hoped results, changing the mind risks to have as only final effect the missed achievement of the preset objective. The consistence is undoubtedly one of the winning qualities of the good investor.
(source of the article is the book "Mutual Funds", Marco Liera, Il Sole 24 Ore) |
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