The pros and cons of mutual funds

• By Frederic de Melker, Special to Gulf News
• Published: 00:00 March 10, 2012
• 

The concept of mutual funds may have been introduced to the wider public just 20 years ago, but what most people don't know is that this investment vehicle was actually created centuries ago.

Inspired by an investment construction created by a Dutch merchant in 1774, King William I of the Netherlands launched the first mutual fund in 1822.

In the 190 years that followed, not only has the product witnessed considerable development, but legislation has been built around the product and regulatory bodies like the US SEC have been introduced.

Despite its long history, individual investors today often perceive mutual funds with mixed feelings. Presented as a golden key that can open any door, the result has not always been in line with what is expected. An oversupply of products has changed clear waters into a turbid pool.

Nevertheless, it doesn't make sense to believe that the concept of the automobile itself is wrong just because you have made a couple of wrong choices in the brands of car. It is the same for mutual funds. It is important to select wisely. Here are some points to look out for:

Chopsticks

The philosophy behind mutual funds is easy to understand. Look at an individual bond or stock as a chopstick. You put on some pressure and it breaks.

A solid mutual fund is like a bunch of chopsticks. If you try breaking it, the resistance is immense.

In the US market some years ago, investing all your money into Enron would have been disastrous.

Investing in a well-balanced US Energy fund, with Enron in portfolio, would have provoked only a three to four per cent loss.

Multi-level diversification

Since mutual funds include a portfolio of individual financial positions like stocks or bonds, they are diversified by nature. When you start combining these products to meet your overall return objectives, the allocation of products will have an extra positive impact on the risk level of your basket of investments.

Open architecture

Getting the right fund manager is important because most specialise in particular segments.

Be it on a geographical, industrial or thematic basis, a sophisticated professional is in tune with his market and sees the woods from the trees.

His approach is based on both qualitative and quantitative grounds. He knows the companies he is prospecting or investing in. He visits CEOs and CFOs regularly, and feels the pulse of his portfolio.

Solid mutual funds are usually actively managed by such fund managers.

As a third level of diversification, it is advisable that you spread your portfolio of mutual funds among different asset management firms. By doing this, you implement different investment styles and market approaches to spread your risk even more.

Profile

Before you start building a mutual fund portfolio you need to determine how it best fits your needs.

There are several ways to make a customised profile by taking into consideration your risk appetite, the tenor of investment and your investment goals.

It is important to take time to do this right. An inaccurate profile may result in wrong investment decisions, which could cost you dearly.

Conclusion

It is certainly difficult for an individual investor to get into mutual fund selection.

The quality differences and almost unlimited choices create a complex maze.

In addition, you need to determine the right mix of products to manage correlation and position overlap.

A wealth adviser can help you make the right choices because he is supported by a team of specialists who know how to compare products based on quantitative and qualitative measures.

The writer is head of priority banking at Emirates NBD. Opinions expressed here are his own and do not necessarily reflect those of Gulf News.