Institutions obtain administrative and, sometimes, taxation benefits by using mutual funds to manage their own assets. Such funds are invariably not available to the general public. Funds that are authorised to be promoted to the general public (frequently referred to as ‘retail funds‘), usually extol the benefits to the private individual, namely:

1. Small investment required

Although both minimum holdings and minimum initial amounts are usually required, individuals can invest comparatively small sums of money in mutual funds, particularly through plans that accept regular subscriptions. So-called ’small investors‘ can thereby obtain the benefits of worldwide economic activity (hopefully growth) rather than allowing these to be enjoyed by the banks (and their shareholders) and others with whom they deposit their funds in return for an interest income.

Funds2. Spread of risk

By ‘risk‘ we typically mean the risk that our investment will depreciate in value or, in the extreme, cease to have any value. In the context of a portfolio of investments there are two aspects to risk and therefore to risk spreading. The first is the effect that failure of any one share within the portfolio has on the value of the Whole portfolio; the second is the effect of general news or events on the prices of all shares, either across the market or on particular sectors of the market. These two aspects each have their own response when constructing a portfolio – the number of holdings and their spread across geographic regions, industry and economic sectors and asset types:

Number of holdings: Money supplied by the participants is invested in a number of different securities in order to reduce the risk of loss associated with any one investment, known to fund managers as ‘unsystematic’ or idiosynchratic’ risk, as distinct from the risk that the whole market may fall, known as ’systematic’ or ‘market‘ risk. A typical fund invests in SO-100 companies in an attempt to eliminate unsystematic risk. If a participant invested his money directly into the shares of one company, he could lose all of it if the company went into liquidation. Within a mutual fund’s broadly based portfolio, only a relatively small amount would be lost as a result of the failure of a single investment.

Geographic, industry or economic sector and asset type spread: This is referred to as diversification. While nearly all funds offer a spread, not all offer diversification and all but the ‘balanced’ or ‘hybrid’ fund offer only limited diversification. A truly diversified portfolio is one that has investments in several different regions, industries, sectors, and asset types, thereby reducing systematic risk inherent in any one market.

While a large number of holdings will reduce, even eliminate, unsystematic risk, the remaining systematic risk will be large if the holdings are concentrated in the same region or sector. While gains or superiorper formance may sometimes be achieved by having all one’s eggs in the same basket, if the basket falls out of favour, it doesn’t matter that it was holding a large number of eggs. Investors in specialist funds, whether industry or country specific, such as technology or Japan funds, can attest to significant losses in recent years, even though their investments were in funds with portfolios of over 100 individual stocks, because the industry or economic sector failed to live up to expectations. It is also the case that diversified but equity-only funds will tend to fail investors in years when there are widespread falls across the major markets, whereas bond funds generally maintain the value of their holdings. While this might suggest that cautious investors should be steered towards international or global balanced funds for the substantial part of their portfolios, even here, currency risk remains a threat to wealth!

3. Professional fund management

Very few individuals have sufficient time or expertise to manage their own wealth with the same degree of competence as a professional. The money invested in a mutual fund is managed by professional fund managers, who have access to a wide range of resources and research data and are ‘close to the market‘, able to spot trends and opportunities as they arise. Unlike the individual investors in the fund, who have other matters on their mind, the professional fund manager can concentrate on achieving the investment objectives of the fund.

4. Cheaper dealing

Although the individual participant’s investment can be small, pooling the contributions of many investors into a single fund allows the investment manager to deal in large quantities and therefore at a lower cost than the individual investor could achieve. While this differential is being eroded by the increasing use of internet dealing, it remains significant and is most marked when the manager has responsibility for a number of funds and utilises a central dealing desk to aggregate or ‘bulk’ portfolio managers‘ orders for execution in the market.

Convenience

A single holding in a mutual fund can be equivalent to a portfolio of possibly 100 individual investments hut without the attendant difficulties of monitoring their individual performance and periodically adjusting the composition of the portfolio. Buying and selling shares or units in a mutual fund is easy, and may be effected directly with the manager without the need for an intermediary. In some circumstances it can be accomplished by telephone and, increasingly, via the Internet or a dedicated electronic exchange. In most countries, the prices of mutual funds‘ shares or units are required to be published in national newspapers, so it is a simple matter on any day to determine the value of the particular mutual fund investment – certainly more convenient than performing 100 different calculations!

5. Reinvestment of income

Many mutual fund managers offer schemes that enable income to be automatically reinvested, either by purchasing additional shares or units, usually without the imposition of an initial charge, or by the use of an alternative share or unit type – the ‘accumulation’ share. This facility is particularly useful if the investor wishes to build a holding and does not need income. Whenever circumstances and hence requirements change, it is normally a simple matter to change to and from automatic reinvestment by advising the manager.

6. Taxation

Deferral of (but not exemption from) tax is a common benefit. In some countries, mutual funds enjoy tax benefits that are incorporated in the construction of the product. For example, in the UK, unit trusts and Oaks are exempt from capital gains tax (CAT) when the manager sells fund investments at a profit. This enables the value of the fund to grow taster than would be the case if tax were to be extracted on realisation of a gain.

Any tax attributable to gains is collected from the individual investors upon realisation of again on their mutual fund holding.

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