Simple Pound

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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Moving on to your second option of investment: exchange traded funds (ETFs). Generally, a fund is a selection of shares (portfolio) which is managed by a fund manager (that was obvious, wasn’t it?) who earns a living by researching companies and making (your) investment choices.

There is a variety of funds out there, which are commonly categorised as mutual funds and index funds. This same principle applies to ETFs, which are a fairly new investment option having only been traded at the London Stock Exchange since April 2000.

And that’s where the main difference between an ETF and a fund lies: ETFs are traded just like shares on the stock exchange and thus require a lower initial financial outlay. While funds commonly have minimum investment levels of a few thousand pounds, ETFs are much cheaper. That is why Richard Jenkins @ MSN Money claims that you should start investing right away even if you only have $100 (~ £ 50; €75) in your pocket (I disagree, but that’s another story…)

Just like their “big brothers”, ETFs track either an index (like the S&P 500 in the US, or the FTSE 100 in the UK) or a specific sector (oil, pharmaceuticals… you name it!) which gives you the security that comes with diversification (i.e. not putting all your eggs in one basket ) without the financial investment needed if you were to build up a diversified portfolio yourself.

Tracking an index doesn’t require much active work (ETFs are called “passively managed”), because it is simply a copy of the shares represented by the index/sector. This means ETFs have the lowest expense ratio that is available for funds and therefore annual expenses won’t eat up most of your gains.

The FTSE 100, for instance, represents the 100 largest companies in the UK (technically the “most highly capitalised companies” - see here for more information), so buying an ETF tracking the FTSE 100 gives you almost guaranteed growth in the long run (the FTSE100 was “born” on 3rd January 1984 @ 1000 base points and closed today at 6,395.40).

Let’s sum up the advantages that come to mind:

• low annual costs
• inherently diversified
• no minimum investment limits (other than the price of the share)
• no time-intense research to pick a “good” company - the number of available options is reduced to 669 worldwide

But:

• stock indices represent the economy’s well-being: if the economy is undergoing a recession the index will inevitably fall
• ETFs tracking sectors are as volatile as the sectors they’re tracking - especially commodities like oil or metals can fluctuate quite badly

After we’ve now looked at exchange traded funds, next on my list: index funds and mutual funds.

Read part 3 of “Investment Choices” on index funds >>

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I have never written a blog before. In fact, I was always fairly unreliable at keeping journals, but this time I have a purpose… I am going to graduate in less than 3 months time and will be earning my first salary. And I think this is a pretty good reason for starting to think about money. There are many, many things I want in life - including material things that come at a cost. And don’t misunderstand me, I love luxury - I love fast cars, good restaurants, quality clothes and cosmetics. But I think it should be possible to afford all these with a little bit of planning and without going into debt.I’ve be using this blog for two purposes: Firstly, I want to keep track of what I’m learning and reading about elsewhere and bundle all this (for me) useful information in one place. And secondly, I want this blog to be my source of motivation where I can keep track of my (financial) goals and encourage myself not to indulge in impulse spending.

So what are my goals?

• Pay back (some of) the money my parents lent me to finance my studies - unfortunately that also includes paying a rather large outstanding invoice for repairs on my mother’s car.
• Fully fund my cash ISA for the tax year 2007/08 - the interest earned on that money is tax free and I don’t want waive free money (especially not when it comes from the government…). I intend to use this money only for long-term purposes. That ultimately includes retirement, but since I’m only 20 years old there will be a few other major expenses (property etc.) beforehand that I plan to cover as effortlessly as possible.
• Accumulate an emergency fund of 3 months worth of expenses - as I am about to move to London, I don’t have much of an idea what amount of money I will need to put aside, but I will find out.
• Build up a diversified portfolio of investment funds - at first, these will largely be index funds but I shall also look into mutual funds to aim for a little more aggressive growth. Following the saying “don’t lay all your eggs in one basket” I will try to diversify the portfolio not only by taking into account the funds’ objectives but also their location - starting off in the UK, I plan to diverge into European, American and international funds, maybe even test out emerging markets.
• Gain experience with individual shares and other alternative investment possibilities - here I will start off with growth shares, on which I have just recently read a fantastic book called “The Zulu Principle” by Jim Slater. Even though it is more than 10 years old by now, I found it very enlightening and helpful - how helpful it will prove in practice shall be seen.

These goals are loosely ordered by both importance and amount of money involved. I will not jeopardise any money on the stock market until I have put enough aside to deal with potential losses. Once I start actively pursuing these goals I plan to put up a graph to track my progress - just like the guys at We’re in Debt did. I hope this will help remind me that I don’t really need that extra pair of shoes until I’ve secured all free money from the government…

And now I really need to go and do some more revision…

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