Be careful when agents try to sell you mutual funds (equivalent to unit trusts in Singapore). Since you do not have the expertise and time to invest on your own, you may feel it is better off to leave your money with the professional fund managers who do it full time. It seems like an easy way out, but there are important issues that you need to understand before you think it is the best way for you to invest.
1) Most actively managed funds cannot beat the benchmark or the index over the long run.
John Bogle, the founder of Vanguard funds and a strong supporter of index funds, analysed the performance of US mutual funds in the 36 year period from 1970-2006. At the start of 1970 there were 355 equity funds. By 2006, only three out of the original 355 funds beat the index consistently over the 36 year period. Hence, your chance of picking the 3 winners is 0.8% and how slim is that? You can easily beat 352 funds by buying the index fund.
2) High fund management fees eats into your earnings.
This is one of the reasons why it is so difficult for funds to beat the index because the annual management fees (2-3%) reduces your returns. Moreover, the fees are fixed no matter how the fund performs – even if the fund had a negative return, the manager still gets paid. Overtime, compound interest can aid you but on the other hand, your annual fund management fees can compound against you as well.
3) Randomness of the market.
Burton Malkiel (author of the once controversial book, “A Random Walk Down Wall Street”) and many other efficient market believers feel that you cannot predict the market and profit from it. Fund managers are therefore, no different from monkeys throwing darts to select the stocks to buy. They may have their own investment system and philosophy, but they cannot disprove the luck factor in their success or failure. The randomness was further addressed by Nassim Taleb in his book, “Fooled by Randomness”. He mentioned that randomness very much determines the success or failure of managers. To answer how some managers managed to be spot on in stocks, he drew the analogy of coin throwing where everyone has a 50% chance of the correct answer. For e.g., we begin with 100 managers, after 1 throw, 50 managers (50%) were right. After second throw, 25…third, 12… fourth, 6…. fifth 3. Thus, this is a simplified example of how the top 3 funds can be spot on for 5 years in a row. So how long more can they sustain their luck? It can be the moment you put your money in, they start to choose the wrong side of the coin.
[Free Ebook] How should you invest your first $20,000?
We asked 14 Singapore finance bloggers to share what they would do if they could go back in time and invest their first $20,000. They can no longer rewind time, but you can learn from their experience and hopefully start with a better footing.
4) Restrictions for fund managers.
Fund managers have restrictions on what they can invest in according to the promise and description of their respective funds. Even if a golden opportunity comes knocking, they may not be able to seize it due to these restrictions. Secondly, if a particular sector or country is undergoing a downturn, they may have to stay invested as stated in their fund objectives. An additional problem also arised when the popular fund gets too big – they have too much money and they cannot just sit on the cash. They are thus pressured to keep the money invested even when there are no good options. In the end, they may end up with second rated investments. It just goes to say, the restrictions and pressures are piled on top of the effect of randomness to make managers more difficult to beat the market.
5) Sales charges.
Like management fees, sale charges (when you buy and sell) eats your earnings away. It is true that there are few funds that can beat the market each year (and it is often true that this year’s top 5 funds will not be the next year’s top 5). You may believe that you just need to identify these top funds each year, you can earn big gains. As we know that there are hundreds of funds out there, your chances of finding the top performing ones are slim. Coupled with the fact that you buy sell frequently, you incur many sales charges, which greatly reduces your returns even if you managed to pick one or two correct ones.
In the future, if someone tries to sell you mutual funds, maybe you can pose these challenges to them. I think if they can defend their products convincingly, they deserve your investment.