Simple Pound

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After I diverged a little bit from my original investigation into investment choices, let’s return and have a closer look at mutual funds this time.

I have already discussed index (tracker) funds in great detail, and while mutual funds and index funds do share some features, in most ways they differ significantly. You’ll hopefully soon see why.

Just as index funds, a mutual fund is essentially a collection of shares bought and administered by a fund manager. Mutual funds can be either bought with the fund company directly or through a normal broker and thus simply like you would buy any other share. While the shares of exchange traded funds (ETFs) are priced throughout the day (which is why they are often compared to ordinary shares) and can thus vary in value throughout the day, mutual funds are only priced once - at the end of the market day.

So why invest in mutual funds? The answer is simply - and you probably would have guessed - diversification. If many people invest in the same fund, large sums of money are made available to spread the investment over a variety of sectors, shares, countries and markets - something you clearly couldn’t achieve on your own, at least not if you don’t belong to Britain’s richest 5. Moreover, mutual funds are actively managed (remember that index funds where what is called “passively managed”), which means that some people devote their entire careers to picking stocks for you. That means they spent their entire days researching companies to find the next winner, the one company that is going to outperform the market in the long run (if it exists).

The advantage that should come with a dedicated fund manager is generally a better performance than e.g. an index like the FTSE 100. Since these people should be able to eliminate the companies whose shares are going to go down, right? Well… sort of. But even those fund managers are human after all, so in the end they are probably bound to make a mistake at some point. The truth is, that only about 15% of available mutual funds outperform the market in the long run. Therefore you will need to do your homework for funds just as you would for company shares.

The downside of actively managed investments is that you will need to pay the person who is doing all the work for you - after all, they want to pay off their mortgage too. This implies that the expense ratio of mutual funds will generally be higher than that for index (tracker) funds, and commonly accompanied by advertising expenses and a high turnover through a more frequent buying and selling of shares than mirroring an index would require. Since every buy- or sell-transaction incurs additional costs the most amazing gains could be eaten away by these additional expenses - a fairly good reason to do your homework properly.

Read part 5 of “Investment Choices” on bonds >>

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