A mutual fund is a collective investment that pools together money from various investors, in order to buy multiple securities, such as stocks, bonds, derivatives, etc.
Who runs it?
A professional fund manager will decide how the capital is allocated and can actively change the ratio and content of this “basket” of investments using financial analysis and expertise, whose assets and goals are detailed in the fund’s prospectus, with the objective of beating the benchmark index (e.g. S&P 500).
Thus, when an investor buys a share of a mutual fund, they are investing in a fraction of all the assets the fund is trading.
How do mutual funds work?
Mutual funds are ideal for investors who either lack large sums of funds for investment, or for those who neither have the inclination nor the time to research the market, but yet want to let their wealth grow. In a fund, after that capital is collected from various investors, professional investors will manage it by making a series of investments in a variety of securities and selling or buying them according to their analysis.The fund house, in return for the service provided and the possible profits, charges a small fee.
Many American workers put their retirement funds into mutual funds through employer-sponsored retirement plans, and from the 80’s to nowadays, we have seen a net increase in the ratio of US citizens that use these kinds of retirement plans, exploiting mutual funds.
When setting aside their money in mutual funds, these households can access a broad range of investments, which can help cut their risk compared to investing in a single stock or bond.
Example
Here’s a simple way to understand the concept of a Mutual Fund Unit. Let’s say that there is a box of 12 chocolates selling for €40. Four friends decide to buy it individually, but they have only €10 each, and the shopkeeper only sells the box. So, the friends then decide to pool in €10 each and buy the box of 12 chocolates. Based on their contribution, they each receive 3 chocolates or 3 units, equating to a Mutual Fund share. The cost of one unit is simply calculated by dividing the total amount by the total number of chocolates: 40/12 = 3.33. So, if you were to multiply the number of units (3) with the cost per unit (3.33), you get the initial investment of €10.
Earnings and fees
● DIVIDENDS
The profits generated from this collective investment are distributed proportionately amongst the investors after deducting applicable expenses and fees. The fund manager, on the other hand, will earn through management fees and possible sales loads (charges whenever you buy or sell shares), no matter what the performance of the fund is.
● CAPITAL GAINS
If a fund sells securities at a profit, the gains are distributed to shareholders as capital gains.
● NAV (Net Asset Value)
Another key part of understanding more about the earnings from a mutual fund is understanding that, unlike stocks or equity, they don’t have a given traded price, in this kind of investment, we talk about NAV (Net Asset Value) which corresponds to the combined market value of the shares, bonds and securities held by a particular fund. If the value of the shares increases, the NAV increases too, and so shareholders can sell their shares at a higher price making a profit.
Types of mutual fund schemes
While investing in mutual funds can be beneficial, selecting the right fund can be challenging. Hence, investors should do proper due diligence on the fund and take into consideration the risk-return trade-off and time horizon, or consult a professional investment adviser. Further, in order to reap maximum benefit from mutual fund investments, it is important for investors to diversify across different categories of funds, such as equity, debt, and gold.
Mutual fund schemes can be open-ended or close-ended and actively managed or passively managed.An open-end fund is a mutual fund scheme that is available for subscription and redemption on every business throughout the year, (akin to a savings bank account, wherein one may deposit and withdraw money every day). An open-ended scheme is perpetual and does not have a maturity date.
A closed-end fund is open for subscription only during the initial offer period and has a specified tenor and fixed maturity date (akin to a fixed term deposit). Units of closed-end funds can be redeemed only on maturity (i.e., pre-mature redemption is not permitted). Hence, the units of a closed-end fund are compulsorily listed on a stock exchange after the new fund offer and are traded on the stock exchange just like other stocks, so investors seeking to exit the scheme before maturity may sell their units on the exchange.
An actively managed fund is a mutual fund scheme in which the fund manager “actively” manages the portfolio and continuously monitors the fund's portfolio, deciding on which stocks to buy/sell/hold and when, using his/her professional judgement, backed by analytical research. In an active fund, the fund manager’s aim is to generate maximum returns and out-perform the scheme’s benchmark.
A passively managed fund, by contrast, simply follows a market index, i.e., in a passive fund, the fund manager remains inactive or passive (to the extent that) since he/she does not use personal judgement or discretion to decide which stocks to buy/sell/hold, but simply replicates / tracks the scheme’s benchmark index in exactly the same proportion. Examples of Index funds are Index Fund and all Exchange-Traded Funds. In a passive fund, the fund manager’s task is to simply replicate the fund’s benchmark index i.e., generate the same returns as the index, and not to outperform the scheme’s benchmark.
Risk factors
Investing in a mutual fund involves various kinds of risks, starting with the standard risk factors that affect any kind of investment, such as the price fluctuation of the securities in which the fund invests, the fact that past results from a fund does not guarantee any future results or furthermore, the sensitivity of the NAV to general movements in the market, like changes in interest rates, currency exchange rates, taxation. Other than these, there are more specific factors, like the liquidity risk for securities that cannot be sold within a fund, meaning that if a security decreases in price, due to specific reasons, and the investor has no possibility to exclude such financial instruments from the fund, it will affect the overall performance of the fund.
Advantages and disadvantages of mutual funds
Advantages
Diversification: By pooling money, mutual funds can invest in a wide range of securities, reducing the risk for individual investors.
Professional Management: Investors benefit from the expertise of professional fund managers.
Liquidity: Mutual fund shares can typically be bought and sold easily, providing liquidity to investors.
Disadvantages
Fees and Expenses: The costs associated with managing a mutual fund can reduce returns.
Lack of Control: Investors have no say in the individual securities chosen by the fund manager.
Market Risk: The value of mutual fund investments can fluctuate with market conditions.
The difference between MUTUAL FUNDs, INDEX FUNDs and ETFs
What is the Treynor Ratio?
The Treynor Ratio is a financial instrument used by investors to measure the performance of a portfolio, computing the excess return earned above a risk-free rate, over the Beta of the portfolio. It was named after Jack L. Treynor, an American economist, who served as the president of Treynor Capital Management in California and considered the work of William Sharpe’s while developing the idea behind this formula.
From this introduction it is relevant to mention that there is no such things like a risk-free investment, but when mentioned it is usually to refer to bonds, notes and especially treasury bills. The term Beta on the other hand is a measure of the systematic risk of the portfolio, meaning that it represents the sensitivity to changes in the overall market.
How does it actually work?
The goal of this ratio is to compare the return an investment makes for each unit of risk taken, more precisely to see if the excess return the portfolio generates is worth taking the additional it involves, compared to a risk-free rate.
When we talk about the risk of an investment here, we always refer to the systematic risk (measured by the term Beta), and not to total risk (unsystematic risk). The difference is that the former takes in account changes in the market as a whole, and it cannot be mitigated by building a diversified portfolio, while unsystematic risk refers to a specific company or industry and it can actually be managed through diversification.
The formula
The term Beta, that we now know is key to measure the sensitivity of the portfolio to changes in the market, when it has a value higher than 1.0 it means that the portfolio will generally be more volatile than the market (usually the market is identified through the S&P 500).When comparing different portfolios, the one with the higher Treynor Ratio will show that it had a better performance in the past, relatively to the risk it has taken. In fact, this is where the importance of the Treynor Ratio lies, the ability it gives to an investor to compare different investments that do not share anything in common, by evaluating their returns based on the unit of risk. Negative values of the Treynor Ratio means the portfolio generally underperformed the overall market but they are usually too complicate to interpret, thus not considered.
Example:
A firm wants to invest part of its revenues in a well-diversified portfolio and is comparing two of them.
The portfolio X displays a return rp = 5.0% and has a beta Bp = 0.9.
A risk-free investment, on the other hand (t-bill) would have performed with a profit of rf = 3.5%.
Thus, the Treynor Ratio would be => Treynor Ratio = (5.0-3.5)/0.9 = 1.66.
The portfolio Y on decides to create a different portfolio with rp = 5.5% and Bp = 0.8%. The Treynor Ratio will be equal to => Treynor Ratio = (5.5-3.5)/0.8 = 2.50.
From the results we can conclude that portfolio Y shows better performance per unit of risk.
The Treynor Ratio for mutual funds
The Treynor Ratio can be very convenient when investors are choosing between different mutual funds:
· Mutual funds constantly face risk, especially systematic risk, since they usually tend to invest in assets that are affected by macroeconomic changes, thus considering the Treynor Ratio before investing in a fund can result to be helpful to picture the risk to reward it has.
· Another key reason for which it can be convenient taking in consideration this ratio, is that along with Sharpe ratio and Jenson’s alpha, they are used to rank the performance of mutual fund portfolios. Indeed, when comparing two portfolios, the one with the higher Treynor Ratio means it performed better in the past. It is worth noting that such Ratio indeed only gives information about past performance, so it might not be that accurate in predicting future performance.
This ratio measures how efficiently the fund manager is able to create a balance between risk and return of the portfolio. Because it uses beta in the denominator, the investor must know that beta indicates the sensitivity of the fund returns to the movements of the underlying benchmark. Therefore, the beta of funds that invest in highly volatile stocks would be higher than that of less volatile stocks. Also, stocks that are highly volatile risk rise and fall faster with the market rally and slump, respectively.
Limitations of the Treynor Ratio
As we mentioned in the introduction, the Treynor Ratio does not account for unsystematic risk. Indeed, different portfolios with the same systematic risk, but different total risk will still show the same Treynor Ratio even if the portfolio which is less diversified will actually have a higher unsystematic risk, meaning that the Treynor Ratio alone is not sufficient to give a clear understanding of the risk of an investment.
Another issue with the Treynor ratio is the lack of accuracy in predicting future performance of a portfolio, for the reason that it is calculated based on historical data, especially in the valuation of mutual funds, since the Treynor Ratio highlights only information of the past investment decisions of such funds, that can and probably will change in the future. Another limitation that is related to the past relationship of this ratio is that the term Beta refers to macroeconomic factors that constantly vary in the course of time and could inevitably affect the returns of the portfolio.
One last concern worth considering about the Treynor Ratio is the non-correlation between its values and the actual returns of a portfolio. For instance, when comparing two investments that have respectively 5.0 and 10 as results from the calculation of the ratio, this will not imply that the latter portfolio will generate twice as much profit of the first.
Differences between the Treynor Ratio and Sharpe Ratio
Treynor Ratio | Sharpe Ratio | |
Risk | It refers to the systematic risk, which depends on changes in the overall market and it cannot be offset by portfolio diversification. | It refers to the unsystematic risk, which depends on changes in the specific firm or industry and can be managed through diversification or hedging. |
Purpose | Its final purpose is to compare the returns from an investment with the average market’s gains. | It is to determine whether an investor is making an actual greater return than the risk-free rate accepting the additional risk in equity. |
So, bottom line difference between the two ratios stands in the risk considered, the Beta for the Treynor Ratio and standard deviation for Sharpe Ratio.
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