Question

Question 3

1. Identify 3 of the 5 advantages of using investment funds over making an investment in an individual security.
2. Explain briefly why the returns earned by investors in index funds has typically been higher than the returns earned by investors in traditional mutual funds.
3. In February of 2019, you bought 800 units in an actively managed mutual fund for $24.66 each. As a result of your purchase, the number of units outstanding was 1,240,768. Over the last 12 months, the fund earned a 42% return, increased asset under management by 288%, and incurred $0.88 per unit in management fees (paid at the end of the period). What is the fund’s current NAV?
4. What is the main difference between a mutual fund and an ETF? (1 mark)
5. Why did ETFs not exist in the 1950s? (1 mark)

Answer 1

a) The advantages of using investment funds over making an invesment in an individual secuirty

1. Risk diversification

The biggest advantage of investing in mutual funds versus stocks is risk diversification.

Every stock is subject to three types of risk: company risk, sector risk and market risk.

Company risk and sector risk are unsystematic risks, while market risk is known as systematic risk.

What is the essential difference between unsystematic and systematic risk?

The stock price of a company may fall if the company's financial performance is poor, even if the market rises.

On the other hand, even if the company performs well, the stock price may still fall, if the market falls.

Mutual funds help investors diversify unsystematic risks by investing in a diversified portfolio of stocks across different sectors.

Hence, mutual fund risk is much lower than individual stocks.

2. Smaller capital outlay

Investors require a large capital outlay to build a diversified portfolio of stocks.

On the other hand, since mutual funds work on the basis of pooling of money, mutual fund investors can have the beneficial ownership of a diversified portfolio of stocks with a much smaller capital outlay.

Investors can buy units of a diversified equity fund with an investment as low as Rs 5,000 only (or even lower for some schemes).

3. Investment expertise

Investing in stock market requires a lot of experience and expertise.

In our view understanding the risk return trade-offs in stock market investments is the most important part of equity investing.

Many retail investors have lost money in share trading because they make poor risk return trade-offs.

Mutual funds are managed by professional fund managers who have sufficient expertise and experience in picking the right stocks to get the best risk adjusted returns.

4. Economies of scale in transaction costs

Since mutual funds buy and sell securities in large volumes, transaction costs on a per unit basis is much lower than what retail investors may incur if they buy or sell shares through stock brokers.

5. Variety of products

Mutual funds offer investors a variety of products to suit their risk profiles and investment objectives.

Apart from equity funds, there are also balanced funds, monthly income plans, income funds and liquid funds to suit different investment requirements.

b) The returns earned by index fund is higher than traditional mutual fund because mutual fund charge more fee from the investor than index fund.

d) The main difference between a mutual fund and an ETF are:-

• Mutual funds have more complex structuring than ETFs with varying share classes and fees.
• ETFs typically appeal to investors because they track market indexes, mutual funds appeal because they offer a wide selection of actively managed funds.
• ETFs actively trade throughout the trading day while mutual fund trades close at the end of the trading day.
• Mutual funds are actively managed, and ETFs are passively managed investment options.