The Relevance of Mutual Funds and Their Relevance over Time - Literature review Example

Finance and accounting: the relevance of mutual funds and their relevance over time Introduction A mutual fund is a kind of an investment fund that is professionally managed and pools funds from several investors so as to buy securities such as bonds and stocks. In addition a mutual fund can be viewed as a firm that pools a group of individuals together and invests their funds in various securities. In such a fund, every investor has a certain amount of shares that s/he owns; representing a fraction of the fund holding. The collective holdings of a given mutual fund are referred to as its portfolio. This implies that an investor usually purchases shares in a mutual fund and every share symbolizes the part ownership of the investor in fund and generates income (Mobius, 2007). Whereas no legal definition exists for the phrase “mutual fund”, it is regularly used to refer only to those combined vehicles mostly under regulation and that the general public can buy. Mutual funds are at times known as “registered investment companies” or “registered companies”. It is important to note that hedge funds cannot be called mutual funds since they primarily cannot be bought by public (Bogle, 2010). Mutual funds are defined by firstly time, which basically is the maturity period, secondly investment type whereby the objectives of the investment are defined. Classification according to maturity period (time) The following are types of mutual funds that are classified on the basis of maturity period (time); open-ended funds, cross-ended funds, interval funds. Open-ended funds-these are funds that are accessible for subscription and therefore can be redeemed on a constant basis. These types of mutual funds are usually accessible for subscription all through the year and hence investors can trade the units at NAV correlated prices. Open-ended funds lack a fixed or a definite maturity date and one of the key aspects of them is liquidity. Close-ended funds on the other hand are funds that have a defined or definite maturity period such as 3 to 6 years. Close-ended funds are thus open for subscription for a particular period at the point of first launch. Normally, these funds are usually listed on a renowned stock exchange (Northcott, 2009). Interval funds-these funds merge the aspects of close-ended and open-ended funds. Interval funds can be traded on stock exchanges and are usually open for redemption or sale at preset intervals on the existing NAV. The following are types of funds that are on the basis of investment objectives. These include; Equity/growth funds-these funds invest a main part of their corpus in stocks and represent the biggest class of mutual funds. Nevertheless, there are numerous kinds of equity funds since there are several various kinds of equities. Equity funds can be categorized on the basis of either the size of the firms invested in or the manager’s investment style. They can be classified as value, growth and blend. Value in this case may refer to a technique of investing that searches for high quality firms usually out of favor with prevailing market conditions and normally classified as low P/E with high dividend yields. Growth is the opposite of value which are firms that have had (anticipated to continue having) steady growth in sales, cash flow and earnings. Blend is the compromise between growth and value and basically refers to firms that are neither growth nor value stocks and are categorized as being in the middle. Equity funds have long term investment objectives of capital growth. On buying shares of growth fund, an investor automatically gets partial ownership of every one of these securities in their fund’s portfolio. Growth funds usually invest at least 65 percent of their corpus not only in equity but also equity linked securities. In addition, these funds also might invest in a broad range of industries together with focusing in more than one industry sectors. Therefore, these kinds of funds are applicable for investors that have high risk appetite and long-term outlook (Northcott, 2009). Debt/Income funds –these funds normally invest in such securities as corporate debentures, bonds, government securities as well money market tools. Debt/income funds invest at least 65 percent of its corpus in fixed income securities. Thus, through investment in debt tools, these funds offer low risk as well as stable income to the owners in addition to capital preservation. Debt/income funds are less volatile as compared to equity funds and usually generate a steady income. Such kinds of funds are appropriate for investors having their key objectives as safety of their capital, with moderate growth (Northcott, 2009). Liquid/Money market funds-these kinds of funds ones usually invest in such short term instruments as Commercial paper, Certificates of Deposits and Treasury Bills for not more than 91days. Liquid/Market funds offer easy liquidity, moderate income as well as capital preservation. These funds are also suitable for individual and corporate investors searching for modest returns on their excess funds (Hall, 2010). Balanced Funds-Offers investments in both fixed and equities instruments according to pre-set investment goals of the scheme. They also provide capital appreciation and stability of returns to investors. Balanced funds are ideal for individuals who desire a combination of moderate growth and income. They usually have a pattern of investing that consists of 40 percent debt instruments and 60 percent equity (Hall, 2010). Gift funds on the other hand invest entirely in government securities. Even though these funds have no credit risk, they are related to interest rate risk. Since they invest in government securities, gift funds are deemed safer than other investments (Hall, 2010). Index funds-the aim of these funds is tracking performance of a particular index for instance the S&P/TSX composite Index. Thus according to Hall,(2010), “Also called tracker funds and unmanaged funds, index funds seek to replicate the performance of a designated index(e.g. the S&P 500,the Russell 2000,the Dow Jones Industrial Average…”.Normally, as the index rises or decreases, the mutual fund’s value will also rise or reduce. Thus, index funds naturally have low costs as compared to mutual funds that are actively managed since the portfolio manager does not engage in much research or have to make several investment decisions (Hall, 2010). Specialty funds-focus on particular mandates and forgoes wide diversification to focus on a specific section of the economy. They include sector, regional and socially responsible funds. For instance sector funds focus on particular economic sectors such as health, financial or technology. Sector funds are very volatile and have a greater potential of huge gains, however, the investor has to accept the fact that the sector so chosen may tank. On the other hand, regional funds facilitate investors to focus on a particular region in the world. This implies targeting a region like Latin America or a single country such as Brazil. One of the benefits of these funds is that they facilitate buying of stocks in foreign states which otherwise would be expensive and difficult. Nevertheless, they also have a high risk and the investor should always be aware of this. Finally, socially responsible funds are also known as ethical funds and normally invest in firms that adhere to the criteria of specific beliefs and guidelines. Such funds usually invest in firms that support diversity, human rights and environmental stewardship and may shun businesses that are involved in tobacco, military and weaponry, gambling and alcohol. The main concept here is getting a competitive performance while at the same time sustaining a conscience that is healthy (Tyson, 2011). Historical perspective The very first mutual funds can be traced back to Europe, in 1774, where one scholar credits a Dutch mercantile with forming the first ever mutual fund. Other origins of mutual funds are uncertain and historians normally refer to closed-end investment firms that were initiated in 1822 in the Netherlands by King William I as being the original mutual funds. The following wave that neared mutual funds comprised an investment trust that was initiated in 1849 in Switzerland. These were trailed by similar vehicles that were created in 1880s in Scotland. Thus the concept of bringing resources together and spreading risk by use of closed-end investments rapidly took root in France and Great Britain and soon made its way in the 1890s to the US. The first mutual fund in the US was the Boston Personal Property Trust which was launched in 1893.A critical step towards the development of present day mutual fund started in 1907 with the formation in Philadelphia of the Alexander Fund, which featured semi-yearly issues in addition to making withdrawals without notice (Fink, 2011). The modern day fund began with the formation of Massachusetts Investors Trust in Massachusetts in 1924.According to Gremillion (2012) “The first open-end fund to be offered to the public at its inception was the Massachusetts Investors Trust, founded in 1924.Within a year, it had attracted 200 investors ,whose 32,000 shares were worth $ 392,000.” (Gremillion, 2012).In 1928, the fund became public, finally producing the mutual fund known presently as MFS Investment Management. This fund was regulated by State Street Investors. Nevertheless, in 1924, State Street Investors began its own fund. Thus 1928 was such a momentous year as far as mutual funds are concerned and saw the launching of non-load fund. In the same year the Wellington Fund was launched which was for the first time included bonds and stocks (Gremillion, 2012).Nevertheless, close-end funds continued being popular with most people in comparison to the open-end funds all through the 1920s.For instance, open-end funds in 1929 accounted for merely 5 percent of the $27 billion industry’s total assets (Gremilion,2012). The 1929 stock markets meltdown saw Congress pass a sequence of acts aimed at generally regulating the securities market and particularly the mutual funds. Thus, the 1933 Securities Act required that every investment sold to the general public, mutual funds included should have sought registration with the SEC in addition to offering potential investors with a prospectus disclosing all the important facts and features regarding the investment. After the stock market regained confidence in the 1950s, there was considerable growth of the mutual funds industry and by the 1970s, there were about 360 funds having 48 billion dollars worth of assets. The industry received massive boost after money market funds were introduced in the late 1970s high interest rate atmosphere .In 1976, the Vanguard Group formed the first retail index fund known as the First Index Investment Trust with John Bogle as its head. It is currently one of the biggest mutual funds in the world and is known as the “Vanguard 500 Index Fund”. In addition, it is assets totaling over $195 billion as at 31st January 2015.The fund industry continued growing in the 1980s as well as 1990s because of 3 main factors; introduction of new products such as international, target and sector funds, tax-exempt bond, secondly the bull market for both bonds and stocks and finally the broader circulation of fund shares, with retirement plans amongst the new circulation channels. Thus mutual funds are presently the most preferred option in particular kinds of quick-growing retirement investments as well as other individual retirement accounts(IRAs) together with defined contribution plans all of which became popular in the 80s (Fink, 2011,p. 9-12). Over the years, mutual funds have grown in leap and bounds and are still growing. Inspite of the 2003 scandals, the financial crunch of 2008-2009, mutual funds industry is still expanding .Thus, the Investment Company Institute(ICI) which is a trade association of the United States investment companies claimed that by the end of 2013,America had over 15,000 mutual funds with fund assets estimated to be in the tune of 17 trillion dollars .According to ICI reports, globally, mutual funds had assets totaling over 30 trillion dollars as at 31st Jan 2015.The mutual funds industry still continues to thrive and grow in spite of the launch of exchange traded funds, separate accounts as well as other competing products(ICI). Relevance of mutual funds Mutual funds are quite relevant and play a significant role in numerous household finances in the world. For instance, as at 31st December 2013, mutual funds accounted for 22 percent of all financial assets in most US households. They also have an important role as far as retirement planning is concerned and approximately 60 percent of all assets in 401(k) plans as well as individual retirement accounts hold their investments in mutual funds. Thus mutual funds are quite relevant in today’s world due to the following features that they have; first and foremost mutual funds can be selected from thousands of mutual funds that are provided by numerous mutual funds firms. According to Basu,(2015),this kind of broad selection offers an investor the flexibility of picking mutual funds that are suitable for his/her objectives as well as risk tolerance. Secondly mutual funds are highly diversified and provide a cost-effective technique of portfolio diversification. Thus an investor instead of purchasing and monitoring several stocks, one can simply purchase a small number of mutual funds to attain a wide diversification at a negligible cost (Basu, 2015). Thirdly, mutual funds are affordable and provide a level playing ground for small investors by bringing the financial markets closer to them. Thus, for just a about the value of a typical stock, an investor can take part in dividend and capital gains distribution of several companies. An investor therefore does not have to spend a lot of their money in investing in every one of such companies separately. This is because mutual funds are capable of spreading commissions, research as well as other correlated expenses over a big asset base, thus effectively reducing the cost per individual fund investor. Fourthly mutual funds are managed by experts or rather professionals implying that an investor is able to access professional money management knowledge at just a rational cost. Thus fund managers normally have finance post graduates with many years of stock analysis as well as experience in investment management (Lang, 2013). Nevertheless, mutual funds have their disadvantages as discussed below; First and foremost, mutual funds just like several other investments do not have a guaranteed return with the possibility of depreciation of the value of the fund. Most governments also do not guarantee mutual funds which means that in case the fund dissolves, investors cannot get any part of their investment. Secondly, although diversifying is a one of the major keys to investing successfully, several mutual funds seem to over diversify. Over diversification also referred to as “diworsification” takes place when investors obtain several funds that are exceedingly correlated hence failing to secure the risk minimising benefits associated with diversification (Lang, 2013). Thirdly mutual funds typically charge fees for their services such as shareholder fees as well as annual fund-operating charges. These fees are usually charged investors irrespective of the fund’s performance and in years when the fund has made no money, it may increase losses. Lastly, the large pool of cash from numerous investors may lie idle at times due to high liquidity requirements that enable funds to honor customer withdrawal as and when requested. Having sufficient cash is good for liquidity, however, when money sits around not working for investors is not beneficial. Thus, it is always important for investors to understand the bad and the good regarding any investment. Hence it is essential for every potential investor to do their due diligence before committing their money in any form of investment (Lang, 2013). Shift in investment behaviour in Germany Investment behaviour in Germany has been shifting for the past 2 decades mostly from investing in equities to investing in more fixed income funds. Non-residents hold the majority of German equities. Nevertheless, the stake of domestic shares held by foreigners reduce during the 2008 financial meltdown, with the heightened insecurity as well as substantial liquidity requirements prompting several investors globally to repatriate their money. The cross-border action of investors, principally in the institutional sector together with the considerable investment flows they are able to produce are mostly the key reasons for the considerable stake in owned by foreigners. Foreign ownership percentage in the flagship index DAX is much more; partly because of its constituent enterprises’ high profile as well as the comprehensive analysis as well as media coverage it is given (Yamazaki, 2013). On the other hand, institutional investors in the domestic segment are by far the biggest investor group and their stake has been static over the years, even though a change has occurred within this segment. To a large extent banks together with financial investors have narrowed their venture in German equities since the 2008 crisis, most definitely due to the rigid regulatory requirements. These have over time been substituted by non-financial institutional investors like holding companies that have effectively increased their stakes in locally listed firms. A preference exists for big German businesses, particularly amongst resident financial investors. There also exists a preference of small, domestic public limited firms for the private investors(Deutsche Bundesbank,2014). From 1988, German equities value has grown over ten times in 3 key cycles according to DAX .Overall, firms in German have since 1988 raised money through Initial Public Offers(IPOs) totaling to 296 billion Euros. According to capital markets information from the Bundes-bank, issuing of new shares strongly picked in the 1990s riding on the back of the boom in the new economy before constricting sharply due to bulky equity price losses in the late 1990s and early 2000 dampening demand in addition to restraining the available funding alternatives for businesses. Thus yearly issuance flattened to less than 10 billion Euros till the start of the 2008 financial crisis. Nevertheless, issuance activity increased even though IPOs were almost non-existent. Recapitalisations characterised this period particularly amongst financial institutions which in some instances had the government subscribing for all the privately placed. The German share price index also known as the DAX is a significant pointer for the German stock market and is measured by Deutsche Borse to track the developments of share price of the 30 biggest German public limited enterprises which are listed on the Frankfurt Stock Exchange.Generally, 3 key stock price cycles can be identified; the DAX index climbed during the 1990s up and until the 2nd quarter of 2000, reaching at what was by then an all-time high of above 8,000 index points. After March 2000,the high technology “New Economy” stocks impacted on the DAX which had declined to one third of its peak level by the 2nd quarter of 2003.Nevertheless,the DAX peaked again considerably during the era of the global economic recovery ,breaking a new record, in the summer of 2007,of above 8100 index points(Deutsche Bundesbank,2014). The local share of the public limited firms in Germany accounted for 42.9 percent of the total market capitalization as at the May 2014,implying that it slightly diminished by 2.6% points recently although amidst some volatility during the 2008 financial crisis. Local investors as a whole had just under one third (29.4 percent) of all German equities with 18.3 percent points being attributed to non-financial investors comprising of all businesses which principally produce non-financial services and goods together with holding companies having stakes in the rest of other non-financial companies. At last count, local mutual funds held 6.3 percent easily making them the most significant group of owners in the financial sector of Germany, with local banks trailing at 2.7 percent and the remaining financial institutions having 1.3 percent. Insurers comprising of the pension funds held a comparatively tiny fraction of German equities (0.96%).Meanwhile households held 11.8 percent stake as at end of May 2014 (Deutsche Bundesbank,2014). It is hard to give a projection of the saving as well as investment behavior of Germans, especially private households .Generally, a growth in the rate of savings could be anticipated because of demographic development .However, this would not essentially raise the current account balance if consumption or investment activity were to considerably rise again simultaneously. Thus a development such as that one would arise specifically if the long term interest rates could continue being at a low level. German finance minister Wolfgang Schauble claimed that the government’s response to a “clear weakening” of the economy will be a change in public expenditure toward investing and a shift from government consumption (Riecher, 2014). References Alan, N. (2009). 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