IN last week's feature, we took a look at some of the concepts behind how stock markets worked. This week, we look at investing in mutual funds, which is different from trying to pick out individual stocks.

The Citibank Guide to Building Personal Wealth says that it is difficult for private investors to achieve good overall returns by picking individual stocks for a number of reasons - including the fact that few retail investors actually have the time or expertise to do a good job of it.

'For the vast majority of people, investing in mutual funds is likely to produce more satisfactory results,' the guide says. A mutual fund is a pooled investment vehicle that gathers money from many investors into a single investment portfolio, which is usually managed by a professional investment management company.When you invest in a mutual fund, you are buying a share of the investment portfolio, and not investing in the management company itself. Mutual funds are actually not a new concept. The first mutual fund appeared in Europe in the 1820s. Today, it is a vast industry, with millions of investors all over the world holding shares in mutual funds.

REASONS FOR INVESTING

According to the guide, there are a number of reasons for investing in mutual funds, including:

• Better diversification. A mutual fund may own 100 or more individual securities, which is far more than most investors can realistically buy.
• Better expertise. In general, professional managers perform better than private investors because they have well defined processes and procedures that allow them to take a more disciplined and less emotional approach. They also have access to better research and company information than retail investors, which enables them to control risk and exploit market and information exchange inefficiencies.
• Less time is involved. If you are a dedicated amateur stock-picker, it can take up all your free time. If you invest in a good mutual fund, less work is generally required.
• Affordability. Sometimes, the price of a stock is so high that an average investor cannot afford to buy it. Mutual funds allow you to invest less, but still be able to 'get a piece of the action' in more expensive stocks.
• Economies of scale. Mutual funds pay much lower transaction charges to trade in the stock market.

That said, not all funds are the same. There are many different types of funds and their objectives vary widely, as does the associated risk.

Funds have objectives to help investors choose what kind of mutual funds they want, according to their own personal investment goals.

There is a dizzying range of funds, from those that focus on growth (which invest in companies the fund managers believe will grow well over time) to funds of funds (which as the name suggests, are funds that invest in other funds).

Hedge funds, however, are unlike conventional mutual funds in that they use a wide range of non-traditional investment strategies to achieve their aims, including futures, options, short-selling, arbitrage and leverage.

'These funds are often less transparent than a mutual fund and may use methods not well understood by the ordinary retail investor,' the guide says.

A fund's net asset value (NAV) is its total assets minus its total liabilities. The market value of a fund's investments changes constantly, so funds generally calculate their NAV at the end of each business day.

A point to note is that, unlike a company's share price, the NAV of a fund is not directly affected by demand from investors, since it is based on the value of the investment the funds owns.

While investors might wish to invest in an initial public offering (IPO) of a company, in the hope that other investors might subsequently want to purchase the shares at a higher price, such speculative phenomena do not apply to mutual funds: for a fund's NAV per share to grow in value, the value of its investments must grow.

The range of mutual funds available offers investors the opportunity to refine their approach to asset allocation and maximise their returns while minimising risk.

ASSET ALLOCATION

The concept of asset allocation considers the correlation between different markets and investment categories, as the particular risk-return characteristics of each investment - bonds, stocks and cash - in different markets are often different.

Different investments that have a tendency to rise and fall together are said to be 'positively correlated', while investments that tend to go in the opposite direction from one another are said to be 'negatively correlated'.

'By combining securities whose returns are not highly and positively correlated, we can reduce the risks with little or no impairment to the return,' the guide points out.

To build a portfolio that fits the individual, one first needs to decide on the risk level the individual is willing to take.

The table below, taken from the guide, shows five basic global bond and global equity portfolio strategies with different degrees of risk.

When investing in mutual funds, one has to note that there are a number of charges which apply, including sales charges - which apply when you buy or sell shares in the fund - and operating expenses, which include the administrative costs of running the fund and the fund manager's fees.

It is advisable to get some professional advice before investing in mutual funds, and you will need to monitor your portfolio regularly and rebalance it from time to time to maintain its optimum risk-return characteristics.

» Risk and portfolio strategies

Information for this article was taken from the book 'The Citibank Guide to Building Personal Wealth'.

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