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Relying on experts or algorithms
One can mitigate risks by relying on experts or well-tested algorithms to manage funds. In USA, publicly traded companies which follow the value investing philosophy include: Berkshire Hathaway, BBTEX, Boyar, Tweedy Borwne, YACKX.
Index funds for a given economic sector simply invest in major companies in proportion to their market value. One relys on the less riskier supposition that the entire sector is likely to grow, rather than any single security belonging to that sector.
Fees
Both index and human-managed funds need to pay brokerage costs. Managed funds usually have greater overhead costs, as they need to pay fund managers.
Over a long period of time, index funds seem to be equal to or better than most managed funds in terms of return on investment/ growth - excepting those following a good long-term investment philosophy.
Expense ratio eats into the annual return and affects performance - IMG. Factor both into account when picking a fund.
Fee types
Various forms of fees are charged: these are separate from trading expenses. The simplest is the administration fees.
To encourage stability in their pool of money by discouraging excessive money-movement, they often charge fees for purchase and redemption of fund shares, and exchange of shares between funds.
Sales loads
A fraction of the investment: front-end load and back-end loads are often imposed at the time of purchase and redemption respectively. These are different from fixed purchase and redemption fees mostly independent of the size of the investment.
This is often to pay brokers who sell mutual fund shares, and encourage long-term investment. For example, back end loads (aka class B shares in the fund) often decrease with time. No-load funds (aka class C shares), being more fluid, carry higher administrative charges.
Rating
Analysts rate the risk/ profit potential of various funds using a 3*3 grid.
In case of bond-funds, one axis is the term of the bonds involved (short, medium, long); and another is the credit worthiness of the bonds involved (low, medium, high).
In case of equity-funds, one axis classifies the companies into value/ balanced/ growth categories, while another axis classifies them based on the capitalization (small, medium, large).
Allocation disclosure
Many actively managed mutual funds disclose their allocation only quarterly, whereas index funds do it every few seconds - especially because of the ability to exchange them for the underlying securities.
Net Asset value (NAV)
The ideal value of a share in a fund can be deduced by the value of the underlying securities. The actual value of a share in the fund additionally depends on the faith of the market in potential value of that share - which may vary with changing allocation and the abilities of the fund managers.
NAV of a security with the symbol XYZ can often be tracked by looking at the charts corresponding to the symbol XYZ.IV.
Critique
Overhead
In recent decades, financial services have become a more central and powerful force in the economy. This has resulted in drain of talent from production and invention to money management, which is fundamentally a overhead.
Dumb allocation, individual greed
As the 2011 real-estate booms in USA, Ireland and the role of investment banks in helping Greece defraud the EU about its financial condition show, the use of deliberately information-obfuscating financial instruments have been on the rise, leading to mis-allocation of funds by misled investors. All this has happened while employees of these institutions received high salaries, and while they were bailed out by governments gifting them taxpayer money to stay solvent (rather than nationalizing them).
Dividend handling
- Equity held by the fund pays out dividends. How is this handled?
- In “Growth funds”, dividends are reinvested by the manager to by more stocks and increase net asset value (NAV) of the fund. The investor does not receive more shares, but their shares of the fund increase in value.
- In “Dividend Reinvestment” funds/ options, dividend is automatically used to increase the investor’s share of the fund.
- In “Dividend payout” option, dividend is passed on to the investors.
Exchange Traded Funds (ETF’s)
Ownership of some funds is shared, and these shares can often be traded in the stock exchange. The value of the ETF shares should reflect the value of the underlying securities in which it has invested, and the belief in the skill of the fund manager, in case of actively managed funds. (ETFs may be index funds or actively managed funds.)
Because index-tracking funds’ investment positions are more readily available, their prices on the stock market more closely reflects the evaluation of the underlying securities - ie. they have less tracking error.
- ETF Price = value of underlying investments + trading costs to create/redeem shares.
Inverse funds
These ETF’s systematically bet on decline in value of a certain set of businesses - perhaps using futures contracts. These involve active management.
Not suitable for buy and hold investors.
Leveraged
These ETF’s use k-times (usually: 2x or 3x) leverage in an effort to increase profits k-fold. These involve active management, and interest needs to be paid. It is even possible for the underlying security to increase in value but for the leveraged ETF to fall in value.
Not suitable for buy and hold investors.
USA examples
One can use Morningstar’s ETF screener to identify performance leaders.
Historically, the S&P 500 index fund has grown at the rate of 17% per annum. During the dot-com collapse, this fund grew at the rate of -1% per annum. During the 1990’s, it grew at the rate of 33% per annum.
The non-profit structure, Vanguard, issues ETF’s.
VTI tracks the entire stock market, MGK: US Mega cap; VEA for Europe; VWO emerging markets; VNQ: high yielding real estate. LAG tracks the entire bond market.
Asia-Pacific: (GMF) gives China a 37% weighting, with Taiwan and India making up another 46%.
Latin america: ILF has had a two-year annualized return of 43.0%.
Energy: XOP.
Indian market
CNX Nifty represents a market capitalization of about 59%. CNX 100 represents about 66.61 % of the total market capitalization as on April 10, 2007. CNX 500 represents about 90% of the stock traded at NSE.
Old note: ETFs corresponding to CNX 500 are not available. ETFs corresponding to CNX NIFTY index are SUNDER and NIFTY BeES. NIFTY BeES seems to be better, in that it has fewer restrictions on purchase amount. It also seems to have a lower tracking error.
Bankruptcy
Big ETF files for bankruptcy and an investor owns their Big Stock ETF. In the case of bankruptcy, the ETF investor would be delivered shares of the actual stocks that were held in the ETF. The investor would suffer no loss and would own the same stocks after the custodian bank delivers the actual shares held by the fund. In reality, it is more likely that another firm would step in to take over management of the fund, which would end in the same result: no impact to the ETF holder. The ETF holder would own the same stocks or investments, even if the provider of the ETF went bankrupt.
Exchange traded notes (ETNs)
- ETN Price = value of underlying index + default risk + supply of shares.
- If an investor holds an ETN, they own a debt instrument issued by a bank or investment firm. ETN holders are lenders whose “interest rate” is based upon the performance of a selected index.
- ETFs are an asset, and ETNs are a liability (debt).
Bankruptcy
Big ETN files for bankruptcy and an investor owns their Big Equity ETN. In the case of bankruptcy, the holder of the ETN becomes a creditor of the firm. The amount of money an ETN holder would receive would be dependent upon the amount of money available after employees, Uncle Sam, and senior secured bond holders get paid.
Debt funds
- Mutual Fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are also referred to as Fixed Income Funds or Bond Funds.
Money market funds
Money market funds are very safe funds which, among other things, focus on making low-risk short-term loans to businesses on the commercial paper market.