Why you should consider investing in mutual funds

You can buy shares and bonds direct or indirectly from a mutual fund. Investment is about foregoing consumption today for more consumption tomorrow.

If you can only afford a kilo of meat worth Sh350 today, forego it and invest the cash for a month, then your investment will only be valuable if you can be able to buy more than a kilo of meat after one month. That makes you better off.

You would have earned a return on your investment. In other words, your wealth at end-month would be Sh525 - a return of 50 per cent. However, in the world of investment, it is different. You can make money or lose money. In our example, the investment of Sh350 could at the end of the month be more or less than Sh350.

Investment is a risky affair and investors must consider time, return and risk. In any project, the investment manager must tame the inherent risk. The wildest variable for investors is risk.

In the securities markets such as Nairobi Securities Exchange, investors are not rewarded for the risk they can avoid.

Fortunately, philosophers in finance have come up with methods that practitioners can use to handle investment risk. The oldest approach to risk management is diversification.

Here, an investor is advised to spread the amount available for investment across assets. Do not have your eggs in a single basket; do not invest in a singular share or bond. The argument is that, as you invest in many assets and your risk exposure reduces.

There are investors who cannot diversify. The way out for small investors is buying units in mutual funds.

If you want to start saving for retirement, but you can only afford to invest a small amount of say, Sh300 monthly, and you want to develop a diversified portfolio, then a mutual fund is the answer. What are mutual funds?

Maximum diversification

Mishkin and Eakins tell us that mutual funds pool the resources of small investors by selling the shares and using the proceeds to buy securities. If 200,000 investors come together and each contributed Sh300 to a mutual fund, the total amount to be invested is Sh60 million. The fund will invest the money in many securities to achieve maximum diversification. From the Sh60 million, the fund will create shares at a value of as low as Sh5 per share. Any investor holding the Sh5 share in the mutual fund will achieve maximum diversification.

Mutual funds have grown rapidly over the last two decades - partly propped up by increases in the number of investors responsible for managing their own retirement. The benefits that investors derive from holding a share in a mutual fund include being able to quickly convert their investments into cash. Investors attach higher value to assets that can be quickly converted into cash.

Secondly, you can participate in the mutual fund in equity and debt issues by corporations which individually require more capital than you possess. Thirdly, you will realise the benefits of diversification even for small investments. The mutual fund can negotiate lower transaction fees than you as an individual investor.

Finally, the fund managers are professionals, and you will benefit from their expertise. However, when choosing an investment fund, know that various types exist. They are stock funds, bond funds, hybrid funds, and money-market funds. It is certain that investors have different objectives, goals, and tastes in securities thus make sure you choose a fund that meets your objectives.

Some funds are closed-ended while others are open-ended. A closed-end fund issues a fixed number of non-redeemable shares that are sold through an initial offering and are then traded over the counter. The price for shares is determined by demand and supply.

In the case of open-end fund investors, you may buy or redeem shares at any point, where the price is determined by the total value of the mutual fund’s stocks, bonds, cash and other assets minus liabilities like accrued fees, divided by the number of shares outstanding.

Who owns mutual funds? The shareholders, or owners, of the mutual fund, are the investors. The board supervises the fund’s activities, hires the investment advisor and an underwriter to manage the day-to-day operations. The fund is not risk-free, but it is exposed to market risks that cannot be gotten rid of. The mutual fund industry has its fare share of scandals.

The experience in the US reported by Mishkin and Eakins, for instance, shows that mutual funds have been subject to scandals for violating regulations and internal policy.

-The writer teaches at the University of Nairobi