A PRACTICAL GUIDE TO MUTUAL FUNDS How Do They Work? What Do They Invest In? Who Invests In Them? Are They Right For Me? www.royalfidelity.com
ABOUT THE AUTHOR Joseph Euteneuer is Vice President of Royal Fidelity Merchant Bank & Trust in Nassau, Bahamas, responsible for mutual funds and business development. His portfolio includes oversight and management of a suite of Bahamian-dollar and USD-denominated mutual funds. He has been active in the Bahamian and offshore fund industry for more than a decade, with sales and management experience in both long-only as well as hedge fund strategies. The idea for creating a practical guide to mutual funds follows years of conversations with clients and potential clients about mutual fund investing, and whether these flexible investment vehicles represent an effective way to grow and manage wealth over time. We hope this white paper provides you with answers to some of the questions you may have had about mutual funds, and helps you along your own path to individual financial freedom. You can contact Joe at: joseph.euteneuer@royalfidelity.com Ph: 242.397.4023 info@royalfidelity.com
SECTION 1: The Basics Introduction History Regulation & Structure
INTRODUCTION Investors often wonder about mutual funds: What are they? How do they work? How do they make money? How do I make money investing in them? What makes them different from individual stocks and bonds? Although the legal structure and tax treatment of mutual funds differs from country to country throughout the Caribbean, the core financial benefit they offer to long-term investors remains constant: an easy-access, lowminimum, professionally-managed and very flexible investment vehicle that individuals can use to build wealth over time. Mutual funds have played a significant role in the growth of the capital markets throughout the Caribbean after first being introduced in Trinidad & Tobago, Jamaica and Barbados in the 70s and 80s. Through their branch networks in the region, various international banks extended the reach of the investment option by introducing clients to the funds that their teams were managing back in their home countries. At the same time that individual company stocks and bonds were being listed on security exchanges throughout the region, generally risk-adverse investors were becoming intimately familiar with the risk level associated with individual ownership of stocks (especially after the financial crisis of 2008!) Caribbean investors looked for a more stable and diversified approach to investing, and mutual funds became a logical alternative. While not immune from the fluctuations of stock prices in the market, mutual funds offered investors two main advantages that individual securities in thinly-traded markets did not: diversification, and (especially important in a crisis) liquidity. 3
Today, the Bahamas International Stock Exchange known as BISX features a mixture of 50 Bahamian Dollar and foreign dollar-denominated mutual funds. And other Caribbean exchanges have experienced similar growth of mutual funds over the years: 34 funds are listed on the Trinidad and Tobago exchange, 18 in Jamaica and 11 in Barbados. Mutual funds have also become the de facto pension vehicle in those Caribbean countries without formal pension legislation mandating that employers offer some type of formal retirement savings plan to employees. The combination of diversification and long-term focus make them just about ideal for pensions. Yet many investors still have questions about the structure and mechanics of mutual funds. The information on the following pages was compiled to help Caribbean investors better understand the ins and outs of one of the most flexible and useful long-term wealth creation tools available in the local market today. 4
HISTORY Mutual funds are pooled investments, strictly meaning that they combine contributions from many different people under an investment company and then purchase a portfolio of assets for the benefit of shareholders (also known as Collective Investment Schemes ). The concept of pooled investing dates back to the late 1700s in Europe, when a Dutch merchant and broker invited subscriptions from investors to form a trust to allow small $40.40 Trillion Assets in global Mutual Funds at the end of 2016 (in USD) investors with limited means to participate in larger investments. 1 Typically, these structures required investors to keep their money within the pool for the entire lifespan of the company, and the actual investments made were often concentrated in one industry or even one company. $19.20 Trillion Assets in U.S. Mutual Funds at the end of 2016 The Massachusetts Investors Trust created the first open-end fund in Boston in March, 1924, introducing important changes to the investment company concept in the process, including a simplified capital structure, continuous offering of shares, ability to redeem shares rather than hold them 1 The Origins of Pooled Investing, Investment Company Institute, 2013 Investment Company Factbook, www.icifactbook.org. 5
until dissolution of the fund, and a set of clear investment restrictions and policies. 2 This became the blueprint for many open-end mutual funds today, in the Caribbean and elsewhere. $2.2 Billion Estimated assets invested in Bahamian mutual funds as of December 2014 By the end of 2016 in the United States, investment companies managed a whopping $19.2 Trillion in net assets on behalf of investors in various types of funds (including Mutual Funds, Exchange Traded Funds, Closed-end Funds, and Unit Investment Trusts). However, the lion s share of this total or $16.3 Trillion was managed within mutual funds. These numbers dwarf the total amount of assets invested in Caribbeanbased mutual funds, estimated to be approximately $2.2 billion today. Nevertheless, the usefulness of the mutual fund structure as an effective and flexible financial planning tool for most investors transcends national boundaries. 2 The Origins of Pooled Investing, Investment Company Institute, 2013 Investment Company Factbook, www.icifactbook.org. 6
REGULATION & STRUCTURE Mutual funds in the Caribbean are governed by country-specific legislation and regulations that reflect the objectives and concerns of the host country. They are required to fulfill all of the obligations related to licensing, reporting, audit, and operation that are prescribed in the legislation, and are generally regulated by a some regulatory body established to oversee the securities industry within the country. Most funds in the Bahamas are structured as investment companies, complete with a Board of Directors, an Investment Manager, a Custodian, HOW MUTUAL FUNDS ARE ORGANIZED Business structure of a typical mutual fund Shareholders Board of Directors Oversees the fund s activities, including approval of contracts with management company and other service providers Mutual Fund Investment Manager Broker- Dealer Administrator Transfer Agent Custodian Independent Auditor Manages fund s portfolio according to the investment objectives outlined in the fund s Offering Memorandum Sells fund shares to the public Calculates Net Asset Value of the fund, processes subscriptions and redemptions, and ensures fund s operations comply with Offering Memorandum Maintains records of shareholder account activity, fund registrations, and other fund documents Holds the fund s assets and maintains them separately to protect shareholder interests Independently verifies the fund s financial statements 7
an Administrator, and an Auditor, all of whom perform important and specific roles for the fund. The company itself is governed by the parameters established in its Memorandum and Articles of Association. Oversight of the ongoing operations of a mutual fund is accomplished through the appointment of a Board of Directors. The board usually consists of reputable individuals who are either associated with the sponsoring company or who provide sufficient expertise in a particular area to assist with the ongoing evaluation and supervision of a fund s operations. As with other non-mutual-fund companies, the Board of Directors meets on a regular basis to review the fund s operations and financials, and to address any related issues. The Board is ultimately responsible for all the activities of the fund. 8
SECTION 2: Mechanics Types of Funds How Funds Work Important Features
TYPES OF FUNDS Three types of structures operate as investment companies: open-end funds, closed-end funds, and unit investment trusts. Although only open- and closed-end funds are offered in the Bahamian Dollar Open-End Fund: An investment company that offers shares on a continuous and unlimited basis and allows for the redemption of shares by shareholders on a scheduled basis. monthly subscriptions monthly redemptions market, several other types of funds are commonplace elsewhere. Fund Unit Investment Trust (UIT). These structures operate similarly to an open-end mutual fund. However, they differ in several important ways: 1) legally, they are established as trusts, as the name implies, and are governed by a trust Closed-End Fund: An investment company characterized by the initial offering of its shares only during a specified period of time. Thereafter, the fund is closed with trading of its shares conducted through an exchange, usually at a premium or discount to the fund s net asset value Subscriptions accepted for a set period of time, then fund closes to new investment deed; 2) from an investment perspective, they are typically passive in nature and do not actively trade securities; 3) they offer investors Fund Shares bought and sold in secondary market, at par, a premium or a discount units rather than shares; and 4) they are typically established with a predetermined termination date. 10
Exchange Traded Fund (ETF). These funds are the new kids on the investment block, having made their debut only 20 years ago, but today represent more than $2.5 trillion of overall US investment company assets. Typically established as an open-end investment company, an ETF nonetheless trades on stock exchanges at market-determined prices, just like a stock or bond. Although they typically mirror a portfolio of securities such as an global equity index or a basket of energy stocks they trade like an individual security and can be bought and sold throughout the day. Closed-End Fund. Closed-End funds occupy the other end of the Collective Investment Scheme spectrum, only offering a predetermined number of shares for sale for a specified period of time. As the name indicates, the fund then closes and any investor who wishes to purchase shares must do so from an existing investor in the secondary market through an Exchange, often at either a discount or premium to the Net Asset Value of the fund itself (ie-the net value of the underlying portfolio of assets the fund owns). 11
HOW FUNDS WORK Many individuals are familiar with bank term deposits and how they work. A fixed time period and a fixed interest rate make your eventual return easy to calculate up front: $100,000 @ 4% interest for one year will earn $4,000 of interest and result in a balance of $104,000 at the end of that year (assuming no money was taken from or added to the account during that period). MUTUAL FUND INVESTMENT PROCESS Mutual fund returns, however, are not generally fixed or guaranteed. Rather, the value of a fund goes up or down depending on the value of the underlying assets. Mutual fund shareholders benefit when the price of their shares increases, which corresponds to an increase in value of the underlying portfolio of securities that a fund buys. As the overall portfolio increases in value, so does the overall value of the fund and the individual shares in that fund. 12
There are two basic ways that individual securities within a mutual fund portfolio increase in value: 1. Capital Appreciation. These are gains in the actual price of a security. Depending on the specific investment objective, a manager might look to buy stock for the portfolio because he believes the price will rise in the future. Perhaps company earnings are improving, or the company occupies a position in the market that has come into favor. Whatever the reason, as HOW A FUND DETERMINES ITS SHARE PRICE Market Value of a Fund s Assets, including income and capital appreciation. Fund s liabilities, including fees and expenses. Number of Investor Shares Outstanding. Fund Share Price or Net Asset Value (NAV) Example: $6,000,000 Example: $60,000 Example: 500,000 Example: $11.88 the securities in a fund s portfolio increase in value, so does the overall value of the fund, and in turn, the individual price of the shares. If an investor buys $100,000 worth of fund shares at a price of $10 per share, for example, he will receive 10,000 shares. If those same fund shares increase in value to $12 three years later--due to the increase in value of the underlying portfolio--that investor s holding in the fund becomes worth $120,000, for a gain of $20,000, or 20% over the three-year period. 13
2. Income. Although many mutual funds do not typically pay dividends or interest directly to shareholders, investors can, nonetheless, profit from the income the portfolio generates. Income from underlying securities is reinvested into the fund, which, in turn, raises the overall assets of the fund and increases the price per share in a manner similar to the previous example. Investors who redeem their shares in the fund at a higher price than they bought them realize a gain that is typically made up of both capital gain and income. The price of shares in a mutual fund is known as the Net Asset Value or NAV. This figure is determined by the fund s Administrator, using a fairly straightforward equation (see previous page). Whether a mutual fund calculates its official NAV daily, weekly, monthly or based upon some other time frame is determined by the fund s Board of Directors. Many funds follow long-standing tradition within their own country to determine the frequency, but overall market activity and liquidity also play a part in the decision. Most Bahamian mutual funds determine their NAV either on a monthly or quarterly basis. Subscriptions into and redemptions from a fund are processed at the same time. When an investor decides to take some or all of his money out of a mutual fund, it s called a redemption. Mutual funds typically require investors to provide some period of notice beforehand, typically 15 days to a month. This restriction gives the fund s manager adequate time to manage the necessary liquidity to pay redemptions and assure a stable flow of monies both in and out of the fund. 14
IMPORTANT FEATURES There are several important documents that mutual fund subscribers should understand. Offering Memorandum. A mutual fund that offers its shares to the public is required to produce an official Offering Memorandum (OM) and to typically file it with the securities regulator in the country. This document discloses the details of the fund, including but not limited to: A Directory of all parties to the fund, such as Investment Manager, Auditor and Legal Advisors An outline of the legal structure of the fund along with its investment objective A list of the Fund Directors Fees and expenses Subscription and redemption process Investment restrictions A list of risk factors to consider cannot do, and who will operate it, before they invest. The purpose of the Offering Memorandum is to provide a complete picture of the fund, so investors can understand the investment objective of the fund, what it will invest in, exactly what the company can and Subscription Form. Mutual funds require subscribers to complete and sign a subscription form, which is considered the contract for the investment. Typical information required on a subscription form includes name, 15
address, verification of the specific fund investment and amount, and the subscriber s signature. The fund s Administrator assures that the investment meets all the requirements of the fund, as outlined in the fund s Offering Memorandum. Subscriber identification and verification. Anti-money laundering legislation and know-your-client regulations in most countries require mutual funds to collect copies of various other documents to verify the identity of the subscriber and the source of the investment funds. These documents typically include a current copy of the subscriber s passport, a utility bill or Voter s Card in the subscriber s name to verify physical home address, the subscriber s national identity card, and a driver s license. 16
SECTION 3: Risk And Reward Investing and Risk Types of Risk The Mutual Fund Advantage
INVESTING AND RISK Investment risk and investment reward are really two sides of the same coin. Investors should not expect to get more reward without somehow assuming more risk. However, many people in the Caribbean are accustomed to the safety and high rates on bank fixed deposits they have received over the years. Some assume that investing works the same way as a bank deposit. It doesn t. When you place money in a HOW BANKS MAKE MONEY fixed deposit at a bank, the bank uses that money to make loans to other banking clients. It pays you a specified percentage rate over a specified period of time in return for the use of your money. As a business, a bank must generate profit, and it makes its money on the spread between the rate it charges for loans and the rate it pays to you on your deposit. For example, if a bank makes a loan at 8% and pays you 3% on your fixed deposit, it makes a spread of 5%. This is how it works. When economic times are good, a bank can generate sufficient loans to maintain its spread and higher deposit rates. But during economic downturns, banks often have to write down or write off loans that are not being 18
repaid as agreed (called provisioning). They then adjust their deposit rates downward to reflect this reality. It s nothing personal, it s just that simple. When this happens, many fixed deposit clients look beyond the walls of the bank for opportunities that can provide them with an acceptable return on their money. Often, this leads them to mutual funds and other investments, which means they are required to assume some higher level of risk than they had with a bank deposit. The graphic below illustrates the standard relationship between risk and return for investments relative to bank fixed deposits. While the risk associated with a bank deposit may be low, so is the relative return. Equities Bank Fixed Deposit Fixed Income R E T U R N Low High R I S K 19
TYPES OF RISK Each one of us takes all kinds of risks every day: walking across the street, driving a car, getting on an airplane. Life is a risk. The key to survival and prosperity is not to try to avoid all risk (which may actually be impossible anyway), but to identify the risks we are willing to take, avoid or manage the ones we aren t, and move forward. When you invest, you automatically assume a different set of risks and Interest Rate Risk Interest rate risk is the possibility that a fixedrate debt instrument will be worth less when interest rates rise. A bond paying a 5% fixed rate will not be as attractive if new bonds are issued that pay 6%. Business Risk Inflation Risk Also known as purchasing power risk, inflationary risk is the chance that the value of an asset or income will be eroded as a future rise in prices for goods or services reduces the value of the cash flow from an investment. Liquidity Risk Business risk is the measure of risk associated with the specific issuer of a security. It refers to the possibility that an issuer of a stock or a bond may go bankrupt or be unable to pay. Liquidity risk refers to the possibility that an investor may not be able to buy or sell an investment when desired or in sufficient quantities. This is especially true in smaller, thinly-traded markets. Credit Risk Credit risk is the possibility that a bond issuer will not be able to make expected interest rate payments and/or principal repayment. Call Risk Market Risk Market risk, also called systematic risk, is a risk that will affect all securities in the same manner due to normal market fluctuations. Reinvestment Risk Call risk is specific to bond issues and refers to the possibility that a debt security will be called prior to maturity. If a bond is called, bondholders must then find another investment that provides the same level of income for equal risk. Most prevalent in a declining interest rate environment, bond holders whose securities mature are often forced to purchase other securities that do not provide the same level of income, unless they assume more credit or market risk. Investopedia 20
a different potential for return than you would if you simply placed the money on fixed deposit at a bank. However, not all risk is the same. Different types of investments carry different levels and types of risk. Investors who buy individual stocks are exposed to more market risk (the normal rise and fall in security prices in the market), for example, than investors who buy fixed income securities. This is because the prices of stocks typically vary much more over time, and, assuming the stock does not pay dividends, fixed income securities pay interest. To make matters even more confusing, investing in a single corporate bond a fixed income security is not without its own set of risks. Bond investors are exposed to nearly all the risks outlined in the chart on the previous page: Interest rate, inflation, business, liquidity, credit, market, call (may or may not apply, depending on the issue) and reinvestment. Understanding the trade-off between risk and return (see graphic, page 19) and how it relates to different types of investments, helps investors determine the right balance of securities that fit their individual risk tolerance. As in life, there is always a trade-off of some kind. And there ain t no free lunch. 21
THE MUTUAL FUND ADVANTAGE Diversified mutual funds pool investor monies to purchase a portfolio of securities from different companies and across different sectors. This spreads the overall risk across the entire portfolio, thus reducing the effect that any single security will have on overall We hope sectors perform like this: performance. Within a diversified equity (ie-stock) mutual fund, for example, the portfolio may contain publicly traded stocks in the following sectors: financial, consumer goods and services, industrial, How sectors actually perform: telecom, and real estate. The hope is, of course, that all sectors advance at the same time for maximum gain. The reality, however, is that they don t all gain or lose at the same time. In a diversified mutual fund portfolio, losses in one area are offset by gains in another, thus reducing the overall volatility and risk of loss. 22
This diversification of risk is one of the main advantages of investing in a mutual fund, as compared to individual securities. While average individual investors could theoretically copy this same approach with their own portfolio of individual stocks, the amount of money required to do so, and the associated trading costs to purchase all the securities, would likely act as a sufficient deterrent. Besides diversification, mutual funds offer several other advantages for investors: Professional Management Mutual funds are managed by investment professionals, who use their expertise and analysis to choose the appropriate securities to buy and sell within the fund. Low Minimum Investment Many funds require only a small investment to become a shareholder. This provides an opportunity for investors who might not have large sums to invest. Liquidity Open-ended mutual funds allow investors to redeem (sell shares back to the fund) on a daily, weekly, monthly or quarterly basis at the current Net Asset Value. The Flexibility flip side of #3, most funds also allow investors to buy additional shares for their account on the same basis at the current Net Asset Value. 23
SECTION 4: Returns Investment Strategies Expected Returns
INVESTMENT STRATEGIES Mutual fund companies around the world offer investors a staggering number of investment options to choose from, including funds that invest in real estate, government bonds, corporate bonds, large cap stocks, small cap stocks, emerging markets, sectors, country-specific, etc. The list goes on, and new funds arrive on the scene every day. In the United States, equity (stock) funds accounted for 56% of all mutual fund assets in 2016, with domestic equity funds (those that invest primarily in shares of US Corporations) accounting for 41% of the 56%, and World equity funds for another 15%. Bond funds held 22% of US mutual fund assets, while Money Market (16%) and hybrid funds (8%) made up the remainder. 1 Vast differences between Caribbean jurisdictions, specific tax treatment of dividend or interest income, regulations, restrictions on nonlocal currency investing, and a relatively small population overall results in fewer overall investment options to investors. But that doesn t mean there are no options. 1 Investor Demand for U.S. Mutual Funds, Investment Company Institute, 2017 Investment Companies Book, www.icifactbook.org 25
Caribbean mutual funds come in five basic types: 1. Growth Funds. Typically invest in local, regional, or international equities, or some combination thereof. 2. Income Funds. Invest in local, regional, or international fixed income, or some combination thereof. 3. Balanced Funds. Invest partly in equities and partly in fixed income. Also known as Growth & Income Funds. 4. Money Market Funds. Invest in short-term, highly liquid securities, certificates of deposit, repurchase agreements (Repos), etc. 5. International Funds. Invest solely in equities or fixed income outside the host country and/or region. Each type of fund pursues a specific investment strategy to achieve its stated investment objective for its shareholders. Recognizing the potential risks and having a reasonable understanding of expected returns from these investment strategies provides an important guide for anyone trying to decide which one suits them the best. 26
EXPECTED RETURNS * Equity funds invest in equities, or stocks, of companies and hope to benefit in two main ways: 1) Increase in share price over time for capital appreciation, and 2) Income they receive from dividend-paying stocks. Funds that pursue #1 exclusively are typically called Growth funds, while GROWTH FUNDS Estimated long-term annual return 6%-8% funds that simultaneously pursue both #1 and #2 are known as Growth and Income funds. Equity funds typically have the highest expectation of return over time, but they also tend to be the most volatile. Stock prices can fluctuate daily in response to a myriad of influences, including economic outlook, financial results, analyst expectations, government actions, etc. As a result, the price per share of mutual funds that hold these securities in their portfolio can also fluctuate widely. FIXED INCOME FUNDS Estimated long-term annual return 2%-5% As the name suggests, Fixed Income funds invest in securities that provide a steady and reliable fixed return, while focusing on preservation of capital. On the opposite end of the risk spectrum from Equity Funds, these mutual funds typically hold a variety of securities in their portfolio, including government and corporate bonds, mortgage-backed securities, preference shares, and cash. Some * For illustration purposes only. Actual returns over time may differ. 27
income funds pay out dividends and interest to shareholders (true to the Income in its description), while others reinvest this income back into the fund, thus increasing the assets within the fund and, in turn, increasing the share price. Some fixed income funds offer two types of shares in the same fund: Distribution for a payout, and Accumulation for growth. Fixed income funds can be an attractive option for older investors, who have a shorter investment time horizon and are more concerned with the preservation of their capital than younger investors, who have more time to make up any shortterm losses. However, fixed income investing is not without its own downside risks such as opportunity risk, interest rate risk, and credit risk that investors should understand before they choose to commit their money. BALANCED FUNDS Estimated long-term annual return 4%-6% This type of mutual fund offers a middle-of-the-road approach, with some allocation to equity and equity-type securities and an allocation to fixed income. The specific investment allocation between the two within different funds can be quite different, but the general rule to be considered a balanced fund is 60% equities and 40% fixed income. Balanced funds provide investors with the steady and relatively secure returns of fixed income investments, along with the juice of an equity allocation that can help boost overall fund returns. 28
MONEY MARKET FUNDS Estimated long-term annual return 1%-2% Widely used in the United States, these funds are highly liquid and geared toward investors who simply wish to park their money for short periods of time in something that yields a little more than a normal bank rates. INTERNATIONAL EQUITY FUNDS Estimated long-term annual return 6%-10% International is simply a term that means the fund invests in securities located outside its home country. Similar to local funds, the investment objective of an international fund can be growth or income or some combination of the two. International equity funds are growth funds, and seek to profit from capital appreciation of the stocks it holds in its portfolio. Although they may also receive income in the form of dividends from the portfolio, the main objective is capital appreciation. These are generally the most volatile of all the fund types offered locally, due to the daily fluctuation of international stock prices and the high level of trading that takes place in developed markets. The ongoing fluctuation in currency valuations can have a significant impact on returns as well. 29
Summary Mutual funds in the Caribbean have provided investors with a flexible and professionally-managed long-term investment vehicle to help prepare for life s big financial commitments, whether that s retirement or college tuition. As investors in the Caribbean continue to experience the painful effects of near-zero fixed deposit rates at banks throughout the region, mutual funds offer a reasonable alternative for growth. We hope this guide provides a helpful overview of how mutual funds work, the different types of funds, and the risks and potential rewards of each in plain and understandable language. Because with this information in hand, you can make more informed decisions about your financial future. And an informed investor is the best kind!