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Investing around the world can be quite daunting for investors whether they reside in London, New York or Tel Aviv. How does one decide how to diversify their investments geographically? Can anybody be an expert on the whole world? How many individual securities (stocks and/or bonds) need to be held in a global investment portfolio to insure sufficient diversification in each country investment? The answer lies in the use of mutual funds.
What are mutual funds?
Mutual funds are regulated companies (by local governmental agencies) that professionally manage a pool of investors' monies. Mutual fund managers invest in different defined asset classes (stocks, bonds etc.) while employing different management styles. Fund management styles may mean a preference for value investments over growth or placing more emphasis on asset allocation (top down) versus individual investment selection (bottom up). Mutual funds compare their performance to a relative benchmark (index) of their choosing. The fund manager may have an investment philosophy that is to mirror the performance of the underlying benchmark. Another fund manager may allow significant deviation from the underlying benchmark. Investments in mutual funds are made through the purchase of individual shares. Most funds trade daily and shares are purchased or sold based the fund's closing price of the same day. The fund's share price is determined by the value of its underlying assets (investment holdings) per share; known as its NAV, or net asset value.
Mutual funds are known as open-end funds because the number of shares in a fund vary daily. This is because when new money comes into a fund, new shares are created. When an investor wants to exit a fund, his/her shares are redeemed by the fund - meaning that the fund buys back his shares. Shares are bought back at the fund's NAV. Most mutual fund minimum investment requirements range from $250 - $500, although, in some cases, they can range from $5,000 - $10,000 and higher.
What is the advantage of investing through mutual funds?
Mutual funds enable small investors to enjoy the same benefits as institutional investors since by investing through mutual funds they are putting the monies with institutional investors. Since mutual funds maintain well-diversified portfolios, an investor can buy fund shares and achieve adequate diversification for a small amount of money. For example, if a European large-cap stock fund owns 70 stocks, it means that every investor's share of the fund represents ownership in a fractional percentage of all the fund's stock portfolio. The mutual fund provides the investor with the benefits and capabilities of its research team in analyzing individual securities, sectors and economic fundamentals of its dedicated geographic region. Many country mutual funds, for example, will have their management team located in, or near, that country enabling them to "feel the pulse of the market." It makes sense. Would you prefer to invest with a local fund manager or a fund manager sitting in the United States to invest in Israeli equities traded locally?
How can I know about the fund manager's investment parameters and style?
Mutual fund companies are required, by their local regulators, to provide a prospectus that must contain all materially relevant information on the fund. The prospectus includes all fees charged to the fund and any additional charges, and it also will describe the types of securities/asset classes permitted for investment and asset allocation guidelines (e.g. an equity fund that is allowed to maintain up to 40% cash). Mutual fund companies also provide sales literature which is geared to highlight the performance and description of the fund. In many cases they will provide details regarding management fees and charges of the fund (see costs and tax issues).
Are mutual funds independent companies or part of a larger entity? Typically, individual mutual funds are part of a mutual fund group. These fund groups may be asset management companies such as Fidelity, MFS, Invesco, AXA Rosenberg etc. They also may be wholly owned subsidiaries of investment banks such as HSBC, UBS, ABN Amro etc.
How does one select a mutual fund?
Selecting the right mutual fund is not simple. According to Standard & Poor's, there are over 116,000 mutual funds, which manage over $10.6 trillion in assets. Statistics show that approximately 15% of all fund managers succeed in beating their benchmarks - fewer manage to sustain their outperformance over time. For example, between 1995 and 1999, 241 US equities funds were ranked in the top 25% of their peer group. Between 2000 and 2001 the same funds experienced a serious shift in their rankings - one of the funds remained in the top 25%, 21 fell to the second 25%, 73 to the third and the remaining 146 fell to the lowest quartile. In addition, there is no one mutual fund group with more than a few top quartile fund managers. The rest tend to be mediocre or worse.
Other issues one needs to address is how the fund is managed. Is it a team approach? Are there proprietary trading systems? Is the manager the main contributor to the fund's performance? Many times investors will choose a fund whose performance may be based on an outstanding fund manager who is no longer with the fund, so it is important to know how long the manager has been with the fund. One of the problems investors face is that mutual funds may be slow to notify investors of changes in the management team. Sources of mutual funds research may be found on the Internet. The most popular are Morningstar and S&P. Both offer free, limited services. A lesser known, though probably the most effective, approach to selecting fund managers is through open architecture.
What is open architecture?
Open architecture is a fund manager screening and monitoring system for the 116,000 funds universe. An open architecture platform is made up of research analysts and analytic software programs providing for quantitative (risk/performance) and qualitative analysis. Qualitative analysis includes the analysis of a fund manager's investment decisions, investment style, returns consistency, identifying relative benchmarks, deviation from stated investment policy, buy/sell decision process, quality of the fund's research, key personnel backgrounds, performance attribution, etc. Qualitative analysis also includes visiting the fund manager's operation and periodic reviews of the fund. Open architecture is geared to identify those 15% of fund managers who outperform their benchmarks and replace those whose performance falters or experience a change in key personnel. Key to the system is the need to insure that there is no compensation issue which might cause a conflict of interest for those screening the fund managers. Open architecture is a $500b. industry in the US. In Europe, investment banks provide the service primarily for institutions and ultra high net worth individuals. In Israel, it is still in its nascent stage; provided by one local investment house.
The author is Global Investment Strategist at Tandem Capital
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