Funds vs Funds

For many first time investors, it is easy to get confused on the best ways to invest your hard earned money. This is especially pertinent in this day and age where we are constantly bombarded with advertisements that promise (unrealistically) high yields. The aim of this blogpost is to describe some of the options available, and the differences between them in order for you to make an informed decision. I will not be addressing insurance, which is a whole new different kettle of fish (though the insurance companies would love to have you think of their products as “investments”).

So what are some of the options available in the market? As shown in the title of this blogpost, there are many funds available for the retail investor, of which I would loosely define them below:

  • Hedge Fund — Generally only available to accredited investors with significant amounts of money to invest, these funds tend to be more aggressive with their investment strategies to obtain alphas. They also typically come with higher management fees (“2+20” being a common fee structure).
  • Mutual Fund — Investment vehicle made out of pooled funds to invest in equities/bonds/other financial instruments. These are managed by money managers who structure and maintain the investments to match the objectives stated in the prospectus.
  • Index Fund — Type of mutual fund that is constructed to “track” a particular index in the market, such as the MSCI World Index or the S&P 500 Index. Index funds provide broad based exposure and diversification, with lower management fees as compared to other actively managed mutual funds.
  • Exchange-Traded Fund (ETF) — Marketable security that is traded like a common stock on a stock exchange. ETFs typically track an index, a commodity, bonds or a basket of assets, and are typically more liquid as they are traded on a stock exchange.
  • “Do-it-Yourself” Funds — As the name implies, this “fund” refers to portfolios that individual investors build.

As you can see from the different definitions, there is no right answer to which fund that you should invest in. Hedge funds are not typically not within reach for “ordinary” investors, so we can discount those funds. For the rest of the funds, we can evaluate them according to your preference along two dimensions listed below:

  • Management fees — as shown in the descriptions above, mutual funds have the highest management fees, followed by index funds, then ETFs. DIY funds of course have no management fees (other than your precious time).
  • “Control” — the level of control that you have over your investments is inversely proportionate to the management fees, meaning that the higher the management fees, the less control you have over your investments. This makes sense intuitively because the management fees are justified by “experts” making “smart” decisions that you would otherwise not make.

It is important to note that (as any financial adviser would caveat)past performance is not an indication of future performance. This author also has certain reservations regarding the value proposition of mutual funds and index funds. My main gripe with mutual funds is that there is strong survival bias with the mutual funds that are currently available to you. It is a little known fact that most mutual funds do not survive or beat expectations in the prospectus. In fact, less than 20% of mutual funds have done so between year 2000 and 2015.

Index funds, on the other hand, have an entirely different problem, which is the perverse incentive to minimize “tracking error”. As index funds are supposed to mirror the indices, many of them are forced to make “bad” trades in order to mirror the indices, many of which diminishes the returns for the investor without good reason.

It is the author’s view that there are no shortcuts to financial success, hence his inclination towards a DIY portfolio. It is worth noting that ETFs are useful tools for small investors to achieve “cheap” diversification which is particularly important for risk management.