In the world of finance, mutual funds (MFs) and exchange-traded funds (ETFs) are often touted as accessible avenues for investment. However, gaining a deep understanding of these financial instruments is essential before taking the plunge. What are they? What is the difference between MFs and ETFs? Are they truly superior to investing in individual bonds or stocks? If these questions have been lingering in your mind, you’ve come to the right place.
To fully grasp the concept of mutual funds and ETFs, it is advisable that readers possess a basic understanding of equities and fixed-income debt instruments. If these terms seem unfamiliar to you, we highly recommend perusing our previous articles in this series: Part 1 (Equities) and Part 2 (Fixed Income).
Now, let’s embark on our journey to demystify mutual funds and exchange-traded funds!
What are Funds?
Both Mutual Funds (MFs) and Exchange-Traded Funds (ETFs) serve as collective investment vehicles, pooling money from numerous investors to create diversified portfolios of assets. These assets include fixed deposits, bonds, stocks, derivatives, and various other securities. These pooled funds are overseen by portfolio managers, seasoned professionals well-versed in the intricacies of diverse investment instruments.
In Singapore, the term “unit trust” is often used interchangeably with mutual funds. In this context, individual investors are also known as “unit holders”.
Funds can be classified based on their asset classes, common types of funds include:
- Fixed Income/ Bond funds → comprising of various fixed income instruments
- Money market funds → short-term fixed-income securities
- Equity funds → comprising of various equity instruments
- Balanced funds → mix of equity and fixed-income securities
- Index funds → tracks a market index
- Specialty funds → specific sectors/industry such as oil, telecommunications, etc.
Mutual Funds vs. Exchange-traded Funds
The key differentiator between MFs and ETFs lies in their trading mechanisms. ETFs are actively traded on stock exchanges, rendering them buyable and sellable throughout the trading day, akin to individual stocks. Examples of popular ETFs include SPY (tracks the S&P 500 index), OIH (tracks the US oil industry), and STI (tracks the top 30 companies on SGX).
Conversely, MFs are bought and sold post-market hours, directly through the managing company or via a broker. Examples of popular mutual funds include VSMPX (tracks the US Total Market Index), SPAXX (consists of mostly US government securities and repurchase agreements), and Eastspring Inv UT Global Technology (speciality fund, technology sector).
Due to their trading mechanisms, MFs and ETFs are priced differently. ETF prices fluctuate throughout the trading day based on supply and demand (similar to stocks), while MF prices are based on their net asset value (NAV). Simply put, NAV is the sum of the market value of all the securities held by the fund.
Furthermore, the trading mechanisms also influence the liquidity of these investments. While both are generally considered liquid, MFs are less liquid due to their once-daily trading window after the market’s closure.
Benefits and Risks
Investing in MFs and ETFs offers the primary advantage of accessing diversified portfolios without the need to individually acquire and manage a multitude of assets. Diversification inherently minimizes risk, and this is further bolstered by the expertise of portfolio managers who employ risk mitigation strategies and continual market surveillance. However, it is crucial to recognize that this reduced risk comes at a cost — management fees.
Moreover, it should be noted that lower risk does not equate to zero risk. MFs and ETFs carry the same risks as most investment instruments, which include:
- Liquidity risk: Both ETFs and MFs have lower trading volumes than stocks and are thus less liquid. Their liquidities are also dependent on their composition and the trading volume of the individual securities comprising the funds.
- Exchange rate risk: This applies to funds invested in foreign securities. For example, if you hold SGD and invest in a MF or ETF that has USD as its base currency, you would lose 5% of your investment value if the SGD strengthens by 5% even if the fund’s price remains constant.
- Equity risk: The inherent volatility of stock prices inevitably influences NAV and ETF pricing.
- Interest rate risk: This risk is more pronounced in MFs and ETFs heavily weighted with debt instruments, as bond prices have an inverse relationship with interest rates.
- Country risk: Political events, natural disasters, and other factors can impact the prices of securities in a given country.
Management Fees
As mentioned, investors incur management fees when investing in funds. Management fees are calculated as a percentage of the fund’s assets under management (AUM). The term commonly used to refer to this percentage is “expense ratio”.
Expense ratios are crucial to consider when choosing between funds. A seemingly small difference in fees can significantly impact your returns over time, especially when compounded. Lower fees mean more of the fund’s returns remain in your pocket.
Furthermore, apart from management fees, there are other types of fees that are not reflected in the expense ratio but should also be considered:
- Sales load: sales charge incurred when buying (front-end loads) or selling (back-end loads) shares of a mutual fund. These loads are pocketed by brokers
- Transaction cost: additional fees incurred when the fund buys or sells securities within its portfolio
Practical Guide to Investing in MFs and ETFs
Now that you’ve gained an understanding of the benefits and risks associated with investing in funds, you might be asking “So how do I start?”. This process closely mirrors the steps for investing in stocks, and can be broken down into three fundamental steps:
- Open a brokerage account and central depository (CDP) account.
- Transfer cash into your brokerage account
- Search and purchase the fund using its Ticker symbol using your brokerage
Brokerage firms serve as intermediaries, facilitating the trading of a diverse array of financial instruments. Unique to Singapore’s financial market, the Central Depository (CDP) records your ownership of securities within the Singapore Exchange (SGX).
Popular brokerage providers in Singapore include CGS-CIMB Securities, DBS Vickers, KGI Securities, and RHB Securities. Keep in mind that each brokerage may have its own set of procedures, fees, and trading tools, so it’s advisable to familiarize yourself with your chosen brokerage’s platform and services. Additionally, you may need to complete various compliance and verification requirements as part of the account setup process, which can vary based on your location and the brokerage’s policies.
Conclusion
This article marks the culmination of our three-part series on investment instruments. We strongly urge investors to meticulously analyse the securities they are planning to invest in and gain a firm grasp of the associated risks before venturing into their investment journeys. If you’re eager to delve deeper into the realm of finance, we invite you to explore our subsequent blogposts!