Mutual Funds

A Mutual Fund in an investment vehicle that allows a group of investors to pool funds to invest in securities, such as stocks and bonds. Mutual funds can be structured in a variety of ways but they are all professionally managed by asset management companies and operate under strict compliance regulation.

Professionally Managed Investment Funds play a vital role in the capital markets and the capital formation of companies as they are, collectively, a significant buyer of corporate securities. Different funds have different investment strategies and specialization and as such, as both active in primary markets for securities and in secondary markets for both stocks and bonds.

Benefits and disadvantages

By pooling resources, mutual funds are able to reap advantages of scale. By operating at a greater scale, these investment funds are able to lower unit costs of administration, transactions and research.

The main disadvantage of investing in a mutual fund is that by outsourcing the investment decisions to the investment manager of the fund, the investor is adding cost layer, that will affect real returns of his investment.

On average, less than half of actively managed mutual funds manage to beat the market – that is, outperform a benchmark of the average performance of the market, such as the S&P500.

Types of Mutual Funds

Although mutual funds share similar administrative and structural characteristics, they can vary drastically in their investment strategies. The most common types of mutual funds are:

  • Money Market Funds invest in short-term government insured debt instruments.
  • Index Funds are passively managed funds that track a predefined index.
  • Equity Funds are actively managed funds that invest in equity securities according to specific investment criteria, such as value or growth.
  • Bond Funds are actively managed where the investment manager aims to identify and invest in undervalued bonds.
  • Income Funds aim to provide their investors with a steady income stream and as such invest primarily in high-quality debt securities.

Active versus Passive Management

Mutual funds are either actively or passively managed. In an actively managed fund, the investment managers perform in-house fundamental research with the aim of outperforming a predefined benchmark, such as an index.

In that context, the return of the benchmark is referred to as Beta and the return of the fund is referred to as Alpha. A positive alpha means that the return of fund was higher than the benchmark.

ETF inflows
In Asset Management, a secular shift has played out over the last decade with funds flowing from Active Management to Passive Strategies. Source: Kinetics Funds

Passively managed funds, also known as index funds, are investment vehicles that aim to track the performance of a predefined benchmark, such as the S&P500 index. Due to their passive nature, these funds have minimal management teams, as their management does not require in-house research.

Open-End Funds

In an open-ended fund, the fund issues and retires units as investors enter or leave the fund, respectively. This means that the investor is buying or selling units directly from the fund.

Closed-End Funds

In a closed-end fund, the fund issues a fixed number of shares which are not redeemable from the fund. Shares of closed-end funds trade on exchanges, which means that new investors are buying shares from departing investors and market prices can deviate from the shares net asset value.

Exchange Traded Funds (ETFs)

An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. They resemble index funds as they are passively managed by tracking a predefined index. However, as they trade on exchanges, the market price can deviate from the NAV of each share.

Asset Management as a Business

As a business, asset management companies, when successful create high returns on invested capital. They benefit from highly scalable business structures as the growth of Assets under Management (AUM) does not require costs to grow at the same rate. In theory, an equity research team, for example, should require the same amount of resources, irrespective of the growth of AUM.

However, with the flow of assets to more passive strategies, mutual funds and the ones with actively managed strategies, in particular, have come under significant pricing pressures. ETFs are structurally more tax efficient and passive strategies require less administrative and management fees per unit.

The Fundamental Finance Playbook has done Security Analysis on companies in the Asset Management Industry: