The untold truth about investing in mutual funds

Investing in a mutual fund can be a passive way to increase and create wealth. Mutual funds are one of the most common investment windows open to investors. Like all other forms of investment, they hold great promises, including risk reduction, dividend reinvestment, and advanced portfolio management.

This article deals extensively and sincerely with the truths about mutual funds that no fund manager may want to tell you.

What is a Mutual Fund

Perhaps you’ve encountered the term “Mutual Funds” without a clear understanding of their nature and operations. Allow me to provide a comprehensive explanation. 

Mutual funds, has its historical roots tracing back to the early 1800s as closed-end investment companies, representing a prevalent form of financial investment. In this structure, a company gathers funds from numerous investors or shareholders, subsequently channeling these resources into a diverse portfolio of stocks and bonds, commonly referred to as securities. The oversight of these funds is entrusted to a skilled fund manager, also known as a portfolio manager, who strategically allocates investments after conducting meticulous financial analyses, focusing on anticipated returns to ensure optimal capital gain or income generation.

Investors in mutual funds seek exposure to a diverse array of assets, including stocks or securities. However, it’s important to note that they do not possess voting rights and may be subject to specific rules, requirements, and fees. The majority of mutual funds are managed and offered by reputable investment management companies, such as Stanbic IBTC Holdings and ARM Investment Managers.

In contrast to individual stocks, which trade based on share prices, mutual funds have a distinct measure known as the net asset value (NAV) per share. The NAV is calculated by subtracting liabilities, which include regular expenses, from a fund’s total assets. This resulting value is then divided by the number of outstanding shares at the market’s closing time.

To illustrate, suppose a mutual fund concludes the trading day with total assets valued at N100 million and liabilities amounting to N20 million, with 2 million outstanding shares. In this scenario, the NAV per share would be N40. It’s crucial to recognize that the NAV fluctuates daily, influenced by changes in the value of individual fund holdings and the number of outstanding shares. This dynamic nature allows investors to stay informed about the current financial standing of their mutual fund investments.

Advantages of Mutual Funds

1. Diversification

Diversifying within a specific type of investment means spreading your money across various companies in that category. This approach is beneficial because it reduces the risk associated with putting all your eggs in one basket and allows for potential returns. However, for beginners, attempting diversification independently can be challenging due to its complexities. Thankfully, mutual fund professionals specialize in managing this process, providing expertise and guidance to simplify the investment journey for you.

2. Advanced Portfolio Management

When you invest in mutual funds, there is an associated management fee. This fee covers the services of professional portfolio managers who handle the buying and selling of diverse investments, such as stocks, bonds, and other financial assets. These skilled professionals oversee the entirety of your investment and employ suitable strategies to efficiently manage your portfolio.

3. Dividend Reinvestment

Your investment experiences swifter growth through the reinvestment of dividends. In the realm of mutual funds, you have the flexibility to reinvest any profits your investment yields, enabling the acquisition of additional units.

This advantageous process can be further streamlined through automation, making the journey of building wealth more accessible and convenient. By consistently reinvesting and expanding your investment portfolio, you create a dynamic pathway for increased returns and potential long-term financial success.

4. Risk Reduction

The majority of mutual funds engage in a variety of investment assets, effectively mitigating risks through comprehensive portfolio diversification. Thoughtful selection of mutual funds presents a valuable strategy for allocating assets and maintaining a well-balanced risk profile.

5. Convenience

Acquiring mutual funds is a straightforward process, taking less than five minutes to purchase units. Moreover, these investments are easily comprehensible, featuring risk levels ranging from low to moderate or aggressive, depending on your willingness to take on risk.

Untold Truths about Investing in Mutual Funds

Now having listed above all that a fund manager will always make you believe, it’s time I let you in on what they might never tell you, and why you need to know before putting your money into such an investment.

The mutual fund manager or advisor may not tell you that:

1. Expenses eat into your returns

Mutual funds could incur various expenses such as fund management fees and loads. While these costs might seem minor initially, over an extended period, let’s say 10 years, they could potentially consume a significant portion, ranging from 20% to 40%, of your returns.

This implies that you are incurring substantial expenses for both fund management and distribution. If the fund fails to generate a substantial “extra return” on your investments, you end up paying high costs for a performance that falls below optimal standards. It’s crucial to acknowledge that in the financial realm, inadequate performance comes at a steep price.

2. You pay even if you lose money

The expense ratio may appear insignificant, seemingly incurred only upon gaining profits. However, in reality, the expense ratio is not inconsequential; you are obligated to pay it even when incurring losses in a scheme.

The total expense ratio (TER), typically falls within the range of 2 to 2.5% (subject to factors like fund size). How does this impact your returns?

 Mathematically, we understand that the time required to double your money (compounded growth) can be roughly estimated by dividing 72 by the rate of return on investment. For instance, at a 10% interest rate compounded annually, it would take approximately 7.2 years to double your money. On the flip side, with a 2.5% expense ratio, you could potentially lose 100% of your corpus in around 30 years. 

This emphasizes why compound interest is often hailed as the eighth wonder of the universe, as famously stated by Einstein. In practical terms, if you manage your funds independently and achieve a similar return to mutual funds, your corpus could be twice as much as what you would have obtained by investing through mutual funds. Everyone aims to enhance their financial well-being, and mutual funds, like any other entity, are not exempt from such consideration.

3. Owning too many stock positions is bad

It’s not often recommended to have an excessive number of funds in your portfolio. Adapting the wisdom of the saying, “too many funds spoil the perfect plan,” the rationale behind this advice becomes clear. Owning numerous funds increases the likelihood that a well-chosen fund may face challenges due to the underperformance of another. This issue is commonly known as “diversification,” where investors assemble a portfolio with so many individual stocks that it becomes contradictory.

Even more counterproductive is the frequent trading of mutual funds. Nowadays, investors tend to hold funds for a mere three years, which is an insufficient timeframe for evaluating the outcomes of an inherently long-term investment program. The situation worsens when the initial selection of funds is flawed, such as investing in funds with inflated performance, those focused on trendy market sectors, funds heavily promoted on television, or funds that engage in active trading and consequently incur significant tax implications. Additionally, funds with high costs may not be apparent as problematic when their historical records appear favorable.

Conclusion 

Mutual funds as an investment portfolio have been really overrated. The running cost paid to fund managers may compound so much over years, even reaching about 40% of one’s dividends and the return over a decade may be low.

Moreover, most fund managers may not do their homework well. While you trust them to make informed choices for you, their only goal is to beat the market with a very marginal gap.

Finally, fund managers most of the time trade common stocks, which are very predictable.

 If this is true, it is noteworthy to state that anyone who can read, write, and comprehend can also buy these stocks and save oneself from unwarranted fees and charges imposed by these fund managers.