Diversification

Diversification

We have all heard of the term ‘Don’t put all your eggs in one basket’ and generally, this saying can be applied to many situations. In investing, it is no different.

In fact, not putting all your eggs in one basket, also known as diversification, is the best strategy to reduce the total amount of risk any individual is exposed to.

 

As an investor holds multiple assets, often across multiple categories, the investment risk is minimized by removing the possibility that any one ‘bad’ asset or company could bring down your entire portfolio.

The rule of thumb in investing is: earning higher returns is only possible by taking on greater risk.

So how does this concept apply to Mutual funds?

In our first article, we discussed the point that mutual funds offer diversification and given that they are professionally managed, it provides value to investors as many investors do not have the skills or time to monitor each investment in the way that a professional fund manager would each day.

Investing in mutual funds, makes the job of diversification much easier as these funds are already invested in diverse holdings. The beauty of mutual funds is that you can invest any amount of cash, based on your financial capabilities, in a fund and obtain instant access to a diversified portfolio. Otherwise, you would have to buy many assets individually in order to create your diversified portfolio which can be costly and time consuming.

Note that no two mutual funds are the same. They are managed differently, have different objectives/goals and are even exposed to different sectors and geographical areas. Therefore, it is advised before investing in Mutual Funds, that you understand the objective of the fund and ensure that it aligns with your investment goals.

Useful Investment Terms

Asset Category – The type of asset that the fund invests in according to its investment objective. These may include equity, fixed income, real estate or balanced.

Assets Under Management (AUM) – This is a fund’s total assets less it’s total liabilities. This term is synonymous with Net Asset Value (NAV).

AUM - See “Assets Under Management”

Balanced Fund – A fund with a diversified portfolio. This will include holdings in equity, fixed-income instruments and real estate. It may also include investments in alternative assets.

Benchmark – A comparative return against which a fund’s performance can be judged.

Benchmark Peer Group Average – The arithmetic average benchmark with respect to a specific characteristic of a Peer Group.

Benchmark Strategy – The strategy of the respective benchmark.

Bid-Bid Return – The holding period return calculated using the ending bid price and the opening bid price

Bond Equivalent Yield (BEY) – This is effectively the holding period return annualized. It however doesn’t recognize the impact of compounding.

Closed-End – A fund which is listed on an exchange such that there is a fixed number of units outstanding so that investors must purchase units from other investors via a market. 

Correlation - See “Pearson Correlation Coefficient”

Direct Fees – These are fees extracted directly from the fund’s assets under management. They include management fees, administration fees and distribution fees.

Distribution – A payment made by the fund to unit holders at the discretion of management.

Domicile – This is the location where the fund is registered. It usually refers to the country.

Effective Annual Return (EAR) – This is effectively the holding period return annualized. It recognizes the impact of compounding.

Equity Fund – A fund which invests primarily in shares listed on a recognized stock exchange. Investments may also be made in equity derivatives.

Excess Return – The holding period return less the risk free rate for the equivalent time period.

Fixed Income Fund – A fund which invests primarily in fixed-income instruments. These include, but are not limited to, bonds, notes, bills, commercial paper and reverse repos. Investments may also be made in fixed-income derivatives.

Fixed NAV Fund – A fund with a Fixed NAV returns a shareholder initial subscription on redemption. The NAV is quoted frequently, but does not change from day to day. Returns to the investor are generally derived entirely from distributions.

Floating NAV Fund – A fund with a Floating NAV fluctuates in value and in the event of redemption, returns the unit-holders proportional share of the market value of the fund.

Fund Class – The units within a fund may have different rights attached to them. Each specific set of rights attached to a respective set of units is called the Fund Class.

Holding Period Return (HPR) – This is the rate of return over any period of time. It is usually calculated as the Bid-Bid Return with the Reinvestment of Distributions. See the methodology for further details on the calculation of this figure.

Inception Date – The date on which a fund begins operations. Also known as the Launch Date.

Indirect Fees – These are fees deducted when an investor purchases or redeems shares in the fund. They may also take the form of a bid-offer price spread.

Investment Manager – The party responsible for the allocation of the assets of a fund. The Investment Manager operates within the guidelines of the Prospectus.

Launch Date - See “Inception Date”

Long-term – Any length of time equal to or greater than thirty six (36) months.

Net Asset Value (NAV) – The total value of assets of a fund less its total liabilities. It can also be viewed as the value of the fund owned by unit-holders.

Bid-Offer Return – The holding period return calculated using the ending bid price and the opening offer price

Open-End – A fund where there is no restriction for entry and exit. However, a holder may still face penalties. For example, they may pay an early exit fee.

Pearson Correlation Coefficient - A measure of the relationship of connection between two securities. It is a number ranging between -1 and +1. Perfect correlation (+1) implies that the two securities move in lockstep in the same direction. Perfect negative correlation (-1), implies that the two securities move in lockstep in opposite directions.

Peer Group – A collection of funds which operate according to a similar mandate/objective. Usually they are funds with the same asset class and currency.

Population Standard Deviation - A measure of volatility or variation computed as the average square deviation from the mean divided by the number of observations.

Primary Class – The main class within a fund. This is usually determined by the class within the most assets/which has the most subscriptions.

Primary Currency – The dominant currency of a fund. This is the currency which the fund uses to receive subscriptions and pay redemptions and/or distributions.

Property Fund – A fund which invests mainly in real estate and/or real estate investment trusts. These funds usually seek gains through rental income and appreciation in market value.

Prospectus – A document which states the overall policies and restrictions of a fund.

Rate Type Distribution – A distribution based on a percentage. This rate is usually annualized.

Redemption - The process by which an investor sells units in a particular open-end fund.

Reinvestment of Distributions – The process of reinvesting distributions paid. This is based on the prevailing Net Asset Value the day the distribution is made.

Risk Free Rate (RFR) – The return on an instrument whose issuer is considered to be default-free. This will generally be a short-term government security, such as a Treasury Bill.

Sample Standard Deviation - A measure of volatility or variation computed as the average square deviation from the mean divided by the number of observations less one

Sharpe Ratio – The ratio of the arithmetic average of the monthly holding period returns to the volatility of monthly excess returns. In
general, the trailing 36 months are used.

Short-term - Any length of time equal to or less than twelve (12) months.

Sponsor – The underwriting company that sells and redeems shares in the mutual fund. The term Sponsor is synonymous with a Distributor. The role of the Sponsor/Distributor is outlined in a Sponsor/Distributor Agreement.

Sub-Peer Group – A subset of a fund’s peer group.

 

Source: Useful Investment Terms taken from Valuehorizon; Caribbean Mutual Fund Journal; December 2013.

How to develop an Investment Plan

How to develop an Investment Plan

• Establish financial goals

  Investors need to establish their financial goals with respect to the requirements from the investment and time horizon for realizing these goals. Goals may be immediate such as making a down payment on a home, paying for a wedding, or creating a university fund. Long-term goals could be like paying for university or retirement. Establishing goals helps to assess how much money you need to invest, how much the investments must earn and when the money will be required.

• Market expectations

  Investors need to study the financial markets to understand the options available to them and forecast realistic market expectation of future performance. Setting realistic expectations about investments and about market performance is an important part of the investment plan.

• Limitations

  Investors may need to make payments in the near future which restrict them from committing large sums of money for an indefinite period.

   
• Risk Tolerance Levels

  All mutual funds involve investment risk, including loss of principle. To generate some returns a certain degree of risk is inevitable. The principle of investing is known as the risk/ reward tradeoff.

Mutual Funds Explained

What is a mutual fund?
A mutual fund is a collective investment scheme which specializes in investing a pool of money collected from investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.

One of the main advantages of mutual funds is that they give small investors access to professionally managed, diversified portfolios of equities, debt instruments which otherwise can be difficult to attain with a small amount of capital. The income earned though these investments and realized capital appreciations are shared with its unit holders in proportion to the number of units owned by them. 

What are the types of mutual fund?
There are basically two types of mutual funds:

• Open-Ended Mutual Funds
• Closed- Ended Mutual Funds

• Open ended

  These are mutual funds which continually create new units or redeem issued units on demand. The unit holders buy units of the fund may redeem them on a continuous basis at the prevailing Net Asset Value (NAV). These units can be purchased and redeemed through the asset management company which announces offer and redemption prices daily.

• Closed Ended

  A fund which is listed on an exchange such that there are a fixed number of units outstanding so that investors must purchase units from other investors via a market. 

Who regulates the mutual fund market in Trinidad and Tobago?

The Trinidad and Tobago Securities Exchange Commission (TTSEC) is the regulator of the local mutual fund industry and is very stringent in issuing licenses to fund management companies, especially in the case of Collective Investment Scheme. The Commission has three primary functions. This includes:

• Registration of all actors  and securities that they offer
• Monitoring and surveillance of the market
• Enforcement of the legislation which governs the functioning of the industry

TTSEC ensures that legal documents affecting the fund's operations are in adherence. This includes: 

• Prospectus/Offering document

  A mutual funds' prospectus describes the fund's goals, fees and charges, investment strategies and risks, as well as information on how to buy and sell units.

• Trust Deed

  a formal agreement/ document used when mutual funds are set up as a trust. Such information includes the powers of the trustee and any restrictions on investment vehicles/ instruments.

• Financial statements

  The statements show the performance of the fund in the outgoing period and help the investor evaluate how successfully the fund has achieved its stated objectives.

How are mutual funds structured in Trinidad and Tobago?
Most mutual funds in Trinidad are operated by an internal asset management dept. The exceptions are:

• Home Mortgage Bank Mortgage Participation Fund is managed by the bank itself;
• The Scotiabank internation's suites of funds are managed by an external, unaffiliated investment team.

Generally the structure is as follows:

• A fund sponsor (usually a bank or large financial institution) establishes a mutual fund. They provide the seed capital and register the fund with the TTSEC.
• The sponsor then appoints a fund manager (the asset management department) to select the investments.
• The manager is responsible for the marketing and distribution of the funds, but this may be handled by another entity known as the distributor.
• The fund must have a trustee, sometimes called a custodian, to hold the funds, pay distributions, and ensure that the fund's operations are in line with its stated investment objectives.

The sponsor and trustee are almost always registered companies. However, the manager and distributor are usually just subsidiaries. The TTSEC regulates the mutual funds themselves - requiring the filing of a prospectus, financial statements, and trust deed. The TTSEC regulates the overseeing manager.

What are the various categories of mutual funds?

• Equity Scheme

  This is a fund that invests in equities more commonly known as stocks. The objective of an equity fund is long-term growth through capital appreciation, although dividends and capital gain realized are also sources of revenue.

• Balanced Scheme

  These funds provide investors with a single mutual fund that invests in both stocks and debt instruments. This is aimed at providing investors a balance of growth through investment in stocks and of income from investments in debt instruments.

• Asset Allocation Fund

  These Funds may invest its assets in any type of securities at any time in order to diversify its assets across multiple types of securities and investment styles available in the market.

• Fund of Fund Scheme

  Funds of Funds are those funds, which invest in other mutual funds. These funds operate a diverse portfolio of equity, balanced, fixed income and money market funds (both open and closed ended).

• Money Market Scheme

  This is among the safest and most stable of all the different types of mutual funds. These funds invest in short term debt instruments such as Treasury Bills and bank deposits.

• Income Scheme

  These funds focus on providing investors with a steady stream of fixed income. They invest in short term and long term debt instruments like government securities like T-bills.

• Aggressive Fixed Income Scheme

  The aim of this fund is to generate high return by investing in fixed income securities while taking exposure in medium to lower quality of assets also.

Why invest in mutual funds?

Mutual funds make saving and investing simple, accessible and affordable. The advantages include:

• Accessibility

  Mutual fund units are easy to buy

• Liquidity

  Mutual fund unit holders can convert their units into cash on any working day. They will promptly receive the current value of their investment. Investors do not have to find a buyer; the fund buys back (redeems) the unit.

• Diversification

  By investing the pool of unit holders' money across number of securities, a mutual fund diversifies its holdings. A diversified portfolio reduces the investors' risk. It would be difficult for an average investor to buy varied securities to achieve the same level of diversification as is available with available investment in mutual fund.

• Professional Management

  Investment managers evaluate all the opportunities that arise in the market, as this is their core business. They carefully examine them and then take decision for investing the mutual fund's money whereas it is not an easy task for an individual and even for corporate company if investing is not their core business.

• Transparent and safe

  Your money is handed over to a professional, whose entire job is to keep track of markets and look out for the best opportunities for you.

• Reduction on transaction cost

  With many people pooling in their savings, you get the advantage of the power of bargaining which reduces the overall transaction cost.