Why should one invest in mutual funds?

Wealthy people have their wealth in form which offers them returns. The forms in which wealthy people park their money is real estate, bonds, debentures, mutual fund units, shares and stock along with others.

Take the example of shares which are in fact part ownership of corporations. If you invest in shares of a corporation you in fact own part of it thus taking part in its future profits and losses.

If you invest shares of Cement Company, you expose yourself to risks affecting the cement industry negatively. Moreover, there are some factors that can affect your company specifically like bad management, technological obsolescence and others.

In order to reduce company specific risk exposure, you need to invest in a number of companies. Likewise, if you want to reduce risk exposure to a certain industry you need to invest in different industries.

The more variety of shares you purchase the less risk exposure you will have. Reducing your exposure to risk by way of investing in multiple securities is called diversification.

Diversification when rightly implemented can reduce your risk exposure. But there are costs associated with buying number of different securities e.g. cost of ordering, accounting, etc. In order to get full benefit of diversification you need to invest a large amount in different securities. An individual has limited amount of capital and cannot diversify, which keeps him away from investing.

The problem of small capital can only be overcome by pooling of funds by different interested individuals. But how to pool funds and also the issue who would manage the funds on behalf of investors arises.

The answer to all these questions can be overcome by utilizing a vehicle called mutual fund.

Mutual funds are pool of funds managed by fund manager for the benefit of isolated investors, who don’t have expertise in the investment field.

When you invest through mutual funds, you benefit from the expert management. The analysts working for the mutual fund industry generates financial models which grows your capital as well as provides protection to your capital.

With Mutual fund investing you also get benefit from diversification, and economies of scale.

The one thing anyone interested in investing through mutual funds should keep in mind that the return from mutual fund is dependent not only on the financial markets performance but also the overall economic performance.

So start investing with good mutual fund manager and select the mutual fund after due diligence.

Disclosure: any thing/ content isn’t substitute of professional advice and the blogging team isn’t responsible for any loss/ damage resulting from acting on information from this blog.

Investing through mutual funds and its benefits

In an article, I have written about benefits of diversification. But small investors face the problem of spreading out their small investing capital across different industries. If you are small investor you cannot diversify effectively owing to variety of factors like having to pay service fees like brokerage commission, minimum investment to be made in one particular security.

The solution to above mentioned problems can be solved by investing through mutual funds. Mutual funds are investment vehicle made up of pool of moneys collected by large number of investors for the purpose of investing in securities, bonds and other financial markets instruments.

There are many benefits of investing through mutual fund. When you invest through mutual funds, you get to enjoy the benefits of diversification. Your mutual fund asset manager has enough capital to invest across variety of assets, hence delivering you the benefit of diversification.

Another benefit of investing through such vehicle is enjoying economies of scale. Your fund can bargain discounted prices for investments. Moreover, other favorable terms can also be agreed because of increased collective bargaining power.

Your fund manager is a professional manager who has learnt about investing through experience and university learning. He is therefore better able to manage your money in a professional style. He can diversify using various statistical techniques. The third advantage of investing through mutual funds is being able to use the skills of professional manager.

There are as many as 40 mutual funds registered with SECP. You can invest in any of the funds mirroring your preferred style of investing.

Some of the funds use aggressive style of investing. They try to generate more returns but the down side is that they are more risky. Some others are income funds, which target generating regular income along with securing your capital.

There are sector funds which invest in specific geographical territory or specific industry e.g. energy mutual funds invest only in stocks and bonds of energy companies. They don’t invest in other industries. As a fund become more specific towards particular territory or industry, its ability to diversify reduces. Try to invest in funds which have consistent track record of generating returns. Although the returns generated by mutual funds are dependent on performance of stock markets.   

There are two types of funds 1. Open ended mutual funds 2. Closed ended mutual funds

Open ended funds are available over the counter and bought and sold on demand. Their net asset value (NAV) is calculated at the end of every trading day whereas closed ended funds are those which are only available on the stock market and has fixed number of shares.

Investing strategies: used by billionaires to amass their fortunes

There are many investing strategies, which investors use. Value investing, contrarian investing and growth investing are mostly used investing strategies. Let’s briefly study them.

Value investing is the most successful investing strategy. It was founded by Benjamin Graham, mentor of Warren Buffet. In this strategy investors see for underpriced securities based on some formula other than market price. This formula for ascertaining the value of the security is generally some multiple of income of the corporation. Value investors usually have to wait for longer in order to realize the full value of their assets.

Along with Warren Buffet many other successful investors follow the value investing strategy of investing. According to researches value investing proved to be the most successful way of investing.  Many billionaire investors favor value investing over other forms of investing. Warren Buffet, Howard Marks, Seth Andrew Klarman, Charles Brandes, Walter J. Schloss, Irving Kahn, Mario Joseph Gabelli, Michael F. Price   are some of most successful value investors.     

Another strategy is contrarian investing. Contrarian investing is buying when other people are selling and selling when other people are buying. Every up and down in the overall stock market or some specific share price offers opportunity of selling and buying to these contrarians respectively.  Warren Buffet is also sometimes referred to as contrarian investor, owing to the obvious reason of many similarities between contrarian and value investing strategy. Other famous proponents of contrarian investing are Michael F. Price, James Beeland Rogers, Marc Faber, David Dreman, Mark E. Ripple, and William Albert Ackman.

Growth investing is another strategy which many successful investors use.  Those who follow growth investing strategy invest in companies that show above average growth even when their shares seem to be highly priced. Unlike value investors, growth investors buy stock in companies that are trading higher than their intrinsic value-assuming that the intrinsic value would grow eventually exceeding current valuations. These investors focus on capital appreciation. Venture capital funds can be classified as growth investors.   

Diversification (Finance) and its benefits

Diversification is the most important technique available to investors. It helps you avoid losing all of your money in financial crisis. Diversification is allocating your investing capital to different asset classes with the goal to reduce your total risk. 

 

But question arises as to why to invest in variety of assets when some may perform poorly.  Why not invest only in assets with greater returns.  The simple answer is that investment returns depend on variety of future events, which nobody can reliably predict.

Diversification can help reduce the risk associated with these future events.

Making diversification effective can take more than simply spreading out your money in more than one asset. The real benefits of your diversification strategy can be fully achieved by owning uncorrelated multiple asset classes which behave differently under different economic conditions.

For example, having a portfolio of 30 oil and gas stocks isn’t diversification. Even owning stocks and bonds may not be sufficiently diversified. Investing in variety of unrelated industries is real diversification.   

Different assets are exposed to different types of risks. If one asset perform badly there are good chances that other assets would perform well and would nullify the impact of bad-performing asset.

Investors should distribute their investments in assets with varying degree of liquidity, risk, and potential of earning. If you are investing in financial markets, you may diversify by investing in real assets like gold or real estate. Financial markets also offer avenues for diversification. Bond market often moves in opposing direction to that of equity. Investing in bonds can save you during period of falling share prices.

Although no amount of diversification can save you from complete disaster but it provides your assets with considerable protection against random events.

   

Provident funds and Gratuity funds

According to Pakistani law provident fund and gratuity funds are two distinct things.  Provident funds are paid to regular employees and gratuity payments are made to contract employees. Gratuity is a tip for good services and therefore its payment is contingent on successful completion of contract. Employees who are removed on disciplinary basis are not entitled to gratuity payments.

Permanent employees are to be paid provident fund at the end of service irrespective of quality of their services. Hence, removal of permanent employee from employment on disciplinary basis doesn’t disqualify him/her for receiving provident fund.

How these funds work

Employer makes regular payment to these funds and these funds are then invested in variety of securities. The returns generated on these funds are reinvested and generally paid to employees at the end of their term.

Employers register these funds as trusts and appoint the trustee who oversee and invest these funds for the ultimate benefit of beneficiaries.

Tax treatment

These funds are exempt from taxes provided they are registered. Any unregistered fund is to be taxed at reduced rate.

Where these funds are invested

These funds are invested in variety of securities. Generally Govt. securities are preferred for the investment as these are secure and there is smaller risk of default. A small portion of fund can also be invested in equity to generate increased return. The problem faced by the managers of the fund is to strike a balance between return and risk.

Federal Govt provident fund

Federal Govt maintains provident fund for its employees. Finance Ministry has notified new rates for minimum subscription to GP fund. Employees in grade 1 has to pay at least 3% of their average salaries in the fund. From BPS 2 to BPS 11 employees has to subscribe atleasat 5% of their mean salaries into the fund whereas BPS 12 and above will have to contribute on minimum 8% of their mean salaries to the fund.

Govt. pays 11.30 % per annum mark up on the fund to civilian employees serving under ministries other than defense and railway ministry.

Challenges for provident funds/gratuity funds

These funds must earn huge returns to pay off the accruing liabilities. This present a challenge to fund manager (trustee), who has to invest these funds in venues where returns outweigh the risk. With one wrong decision, the fund manager risks millions of workers’ hard earned money. To find a right balance between risk and reward a manager employees the services of financial analysts. These professionals make sure that workers’ hard earned money doesn’t wipe away in market crashes.