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Diversification through mutual funds reduces risks
The well-known proverb “Don’t put all your eggs in one basket” has become a guiding principle in the investment world. In 1952 the Journal of Finance published Portfolio Selection by Professor Harry Markowitz which introduced the modern portfolio theory, also referred to as the modern investment theory.
The theory states that the risk for an individual investment has two components, systematic risk which is a risk that cannot be diversified away and unsystematic risk to specific investment which can be diversified away as the number of investments in a portfolio is increased.
A company or collective investment vehicle that pools money from many investors and invests in stocks, bonds, and other securities and assets, or a combination of assets, is known as a Mutual Fund.
Depending on the market geography and structure, they are also referred to as Unit Trusts, UCITS and SICAVS. Mutual Funds can take the form of an Investment Company, which can be a corporation, trust, partnership or other legal structure.
The company will issue securities, shares in the fund, and will invest the monies received from the investor in a portfolio, the combined holdings the fund owns.
A prospectus of the fund contains the investment objectives and goals of the fund, the strategy for achieving these goals, as well as fees, expenses, risks and past performance. The fund issues shares or units and each represents an investor’s proportionate ownership of the fund’s holdings.
There are different types of Mutual Funds. An Open-end mutual fund continuously sells and buys back shares from investors at the net asset value per share of the fund, calculated daily. The Net Asset Value (NAV) is the current market value of the fund’s assets, minus the value of its liabilities. The per share value is calculated by dividing the Net Asset Value by the shares outstanding.
While there is no theoretical limit to the shares that can be issued, the fund will generally limit its issuance if it becomes too large to achieve its objectives. A Closed-end fund sells a fixed number of shares at one time through an IPO that subsequently trades in the secondary market. Unlike Open-end funds, which are valued at current market each day, Closed-end funds trade on an exchange and the price can be at a premium or discount to the net asset value.
The main advantages of Mutual Funds are diversification, professional management, and liquidity. With a minimum investment, an investor can diversify their portfolio across a wide range of companies and sectors which can help reduce risk.
Further diversification can be attained by investing in multiple funds which invest in different categories of investments. Investors also benefit from professional money managers who research, select and monitor the performance of the fund’s investments in compliance with the prospectus. Investors can easily sell their shares back to the fund at the daily NAV per share, or in the case of Closed-end funds immediately on the exchange.
Mutual Funds, chosen wisely, are an excellent component to an investment strategy, which aligns well with Professor Markowitz’s generally accepted modern investment theory.
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