My Mutual Funds 101

Mutual Funds 101 in the Philippines

Here Ive compiled some general information that I hope can be useful to people who want to start putting in money in mutual funds as well as some common terminologies that you would encounter and how to deal with them. Happy Reading!

The Net Asset Value p er Share  or  NAVPS is the price  of purchasing a shar e in  the mutual. Think of the NAVPS as the book value of a mutual fund. In other words, if a fund liquidated all of its assets, paid its liabilities and distributed the remaining to all shareholders, you would receive an amount equivalent or near to the NAVPS. All funds calculate  NAVPS daily based on the closing market prices of their underlying securities (stocks, bonds, deposits, etc.)

The offering price is the price at which mutual fund shares are sold to the public. It is equivalent to the NAVPS + applicable front-end sales charge. Sales charge can either come in the form of front-end loads or back-end loads (back-end means you are charged a % of your proceeds when you sell your share). Funds without sales charges are called no load funds. Always ask if the fund charges any sales load whether front-end or back-end (most funds have options for both and will allow you to choose). Back-end loads that are kept for more than 5 years are usually waived. Sometimes funds also require you to stay invested for a certain amount of time and failure to do so would incur early redemption charges. Ask the mutual fund how this would affect your purchase price. If possible ask for sample computations.

Like any other company, a mutual fund incurs annual expenses (management fees, distribution fees, administrative fees, other expenses). Collectively these expenses are also known as the expense ratio and are usually represented as a percentage of the fund’s total assets. They typically range from 1% to 3%.   This is a very important number as whether or not the fund earns, you continue to pay the expenses. The daily NAVPS computation already takes into account the fund’s operating expenses. In my view 2% is the maximum expense ratio  tolerable unless the fund is able to produce returns that are significantly higher than other funds.

There are typically several types of funds depending on any combination of their underlying investment but they generally fall in the following categories:

1. Equity Funds – primarily invested stocks. Suitable for those with an aggressive risk profile and long term outlook. In my view long-term would at the very least be 10 years.
2. Bond Funds – primarily invested in bonds. Suitable for those with a moderate risk profile and medium term outlook.
3. Balanced fund – primarily invested in a stocks and bonds. Suitable for those with a moderate to slightly aggressive risk profile and medium to long term outlook.
4. Money market fund – primarily invested in government securities or short term deposits with maturities of less than a year. Suitable for those with a risk adverse profile with short term outlooks.
5. Index Fund – primarily invested in stocks with the same weights as with the and attempts to track the index such as PSEI

There could be several other types of funds such as international funds, dollar funds, high dividend funds, etc. all of which differ based on their underlying investments. You should check the mutual fund fact sheet or prospectus to find out more about each fund.

Most funds compare themselves to a benchmark and you should invest in funds that do better than their own benchmark. More importantly you should also look for funds that already have a proven track record of at least 5 years. The longer the track record the better as this gives you a better picture of how well a fund truly is performing especially if it has already gone through a market crash.

You should look at the annualized performance of a fund not only at its 5 year or 10 years annualized performance but the performance since its inception as this would provide you the most accurate basis of return. Ask the fund how they computed for their annualized performance whether this is the same as the compound annual growth rate (CAGR) computation or just simply total return divided by # of years. Always ask for the CAGR performance because the CAGR shows the true compounded growth rate or the geometric mean. A CAGR of 10% means that your money in the fund gets compounded at 10% annually.

Ex. You invested PHP 1,000 in ABC Fund and received 10 shares with a NAVPS or purchase price of 100 (assuming no sales load).

After the first year the NAVPS grew by 100% so it is now at 200

Year 1 return: PHP 2,000 (200 NAVPS X 10 shares)

The following year the stock market crashes and the fund’s NAVPS is reduced 50% so it is now back to 100 (.50*200).

Year 2 return: PHP 1,000 (100 NAVPS x 10 shares)

If you calculated your average return, it would have been 25% (100% for the first year, -50% for the second year)/2 years. Using the 25% average annual return, you would expect that over the 2 years your investment would have amounted PHP 1,562. Clearly this is not the case and in fact, you only ended up with your original investment. The CAGR computation in contrast would show 0% compounded growth which is the true return.

You can earn from mutual funds when they give out dividends, capital gains distribution or when you redeem your shares (i.e. sell your shares back to the mutual fund which is obliged to buy them back from you). Note that you are not taxed when you redeem your shares. You are however taxed 10% on cash dividends received. Because of this, some funds don’t declare cash dividends and retain the earnings to increase the NAVPS but be sure to ask your mutual fund first on their policy regarding dividend distribution as well as capital gains distribution.

The type of fund you invest in would depend on your risk profile and investment horizon. If you want to maximize returns then look to invest towards equity funds. Remember that these are long term funds and as such should remain invested for at least, in my opinion, 10 years. The prices may fluctuate sharply in any given year and you should have the stomach to see your investment lose 80% or more of its value (assuming a very big crash). However should your financial adviser or fund manager advice you that it is time to unload your shares in the fund then you would do well to listen to their advice as well. If you see trouble ahead, there is no shame in asking them what they think of the situation and whether you should be looking at lightening your shares in the fund.

In general look for funds that have:

1. proven track records of at the very least 5 years. the longer the better
2. low expense ratio
3. low front-end loads or waived back-end loads if you hold for at least 5 years
4. outperform their indicated benchmark
5. outperforms or is in-line with other funds that have the same investment objectives (i.e. compare equity funds with other equity funds)
6. CAGR that is at the very least higher than the rate of inflation
7. Shareholder friendly meaning they are prompt to your requests, easy to talk to, transparent and willingly give out any information you ask in relation to the fund

Buying mutual funds through banks may have other fees associated with them such as trust fees so ask how this would affect your investment and ask for sample computations if necessary.

One popular strategy is to cost-average your way into funds (i.e. put lump sum amounts of money each month as opposed to one huge lump sum). This is to ensure that you don’t put all your money in when the prices are too high and also allow you to put money in when prices go low.

As with everything else, mutual funds do not guarantee you anything. If something happens and economies around the world fall, chances are you will lose a significant amount of your holdings. Diversify your investments as much as possible (you could possibly do this by purchasing shares in an equity fund and a bond fund so that if stocks crashes, bonds might still do ok) and always keep emergency money of at least 6 months to a year worth of monthly expenses.

Ask for the mutual fund prospectus (you should by law be given one) as this would detail some policies and information regarding the fund.

Unit Investment Trust Funds are another alternative that banks offer. In essence, they are the same as mutual funds so just the same be sure to read about the fund’s performance and objectives.

Be sure to seek financial advice from professional financial advisers to maximize market opportunities and to address your financial circumstances.