Way to Riches

Mutual Fund

What is a Mutual Fund? A mutual fund is a pool of money managed by a professional money manager. The objective and the risk level are outlined in a document called a prospectus. The prospectus provides detailed guidelines for the types of investments the manager can purchase. A mutual fund is also known as an open-ended investment fund, which means the fund sells units (of this pool on money) upon request.

What are the benefits of purchasing a mutual fund? 1Professional Management: The fund company hires talented money managers who have many resources behind them (including a team of people dedicated to researching, tracking, determining trends, and doing thorough analysis), and who work full time on your behalf. 2Diversification: Lowers the risk because, regardless of the size of your investment, each unit purchased is made up of many different investments. 3Liquidity: Mutual funds can be sold anytime, and easily 4Flexibility: Mutual funds allow you to purchase as much or as little as you want, and offer a variety of purchase plans.

What are the fees? Mutual funds can either be purchased through a: 1Front-end load: An investor pays a fee upfront (usually, a percentage of the total investment). 2Back-end load: An investor doesn't pay an initial fee, but they are locked into the fund family for a predetermined period of time (outlined in the prospectus). If the investor holds the fund to "maturity"of the "contract," they will never pay a fee. But, if they choose to redeem early, they will have to pay a redemption fee, which decreases on a percentage basis every year the fund is held.

What types of funds can I buy? Major Asset Classes: 1Money Market Funds 2Bond Funds 3Balanced Funds 4Dividend 5Equity Funds 6Specialty Funds

What is a Money Market Fund? This type of fund's main objective is to hold investment instruments that are liquid and secure. This type of fund is usually held on a short-term basis and invests in money market securities. Examples: Treasury bills, banker's acceptances, and short term notes. One thing an investor should be aware of is that these funds are NOT guaranteed like a Fixed deposit, and hold NO fixed return, but are of low risk.

What is a Bond Fund? This type of fund's main objective is to provide a steady stream of income, and holds bonds issued by either governments or corporations. The risk level of this type of fund will be determined by the guidelines in the prospectus, which will, in turn, determine what type of "rating" and term (years to maturity) of bond the manager is allowed to purchase.

What is a Balanced Fund? This type of fund's main objective is to hold an optimal mix of investments among cash, equities, and income-producing securities. This type of fund usually has several managers who specialize in a specific area. This type of investment is ideal for someone who wants a better return than a fixed income, but also wants less risk than equity.

What is an Equity Fund? This type of fund's main objective is to provide long-term growth through equity/stock investments. Different types of equity funds: 1Diversified Equity Funds 2.Sector specific Funds 3.Index Funds 4.Middle Capitalization Funds 5.International Equity Funds 6.Others

What is a Specialty Fund? This type of fund's main objective is to concentrate its holdings in one particular sector, geographic region, or in one capital market. Examples: telecommunications, health care, technology, financial services, European markets or Japan. *As you specialize, you minimize diversification, and that results in increased risk.

What are the three different investment styles for equity investing? Fund managers have different styles of investing. Their style affects the type of stocks they will purchase, and the price they are willing to pay. This, in turn, affects your future returns. 1Value: A manager purchases stocks that offer value at a time when the price of the stock is low, relative to the actual book value. In other words, the company is selling for less than it is worth. * Note: This is the most conservative approach.

What are the three different investment styles for equity investing? 2Growth: A manager purchases stocks that are deemed to have growth potential, which, in turn, could generate above average returns in the future. * Note: Growth investments are usually small- to medium-sized companies, thereby increasing the risk exposure.

What are the three different investment styles for equity investing? 3Momentum/Sector rotation: A manager purchases sectors that are, or that they think will soon be, "hot." The choices are determined by the manager's anticipation of where the greatest potential rests. * Note: This is a high-risk way of investing. Other investments with structures similar to a mutual fund include clone funds, and segregated funds.

Performance Measure The Treynor Measure The Sharpe Measure Jenson Model Fama Model

The Treynor Measure Treynor’s Index (Ti) = (Ri - Rf)/Bi. Where, Ri represents return on fund, Rf is risk free rate of return and Bi is beta of the fund.

The Sharpe Measure Sharpe Index (Si) = (Ri - Rf)/Si Where, Si is standard deviation of the fund.

Jenson Model Required return of a fund at a given level of risk (Bi) can be calculated as: Ri = Rf + Bi (Rm - Rf) Where, Rm is average market return during the given period.

Fama Model Required return can be calculated as: Ri = Rf + Si/Sm*(Rm - Rf) Where, Sm is standard deviation of market returns. The net selectivity is then calculated by subtracting this required return from the actual return of the fund.

Use of Models Among the above performance measures, two models namely, Treynor measure and Jenson model use systematic risk based on the premise that the unsystematic risk is diversifiable. These models are suitable for large investors like institutional investors with high risk taking capacities as they do not face paucity of funds and can invest in a number of options to dilute some risks. For them, a portfolio can be spread across a number of stocks and sectors. However, Sharpe measure and Fama model that consider the entire risk associated with fund are suitable for small investors, as the ordinary investor lacks the necessary skill and resources to diversified.