Not all funds are created equal

PUBLISHED ON Monday, 16 August 2021

Introduction

Money in a mutual fund is predominantly invested in stocks – that is, in shares with different companies (joint-stock companies). With mutual funds, you’re not investing your money in one single stock, but rather in different ones. Many funds consist of 50 or more stocks.

Mutual funds often have a content-based focus. For example, they might focus on stock with companies from a certain region (Europe, the U.S., or developing or newly industrialized countries) or from a certain industry, such as biotechnology or machine building.

If you buy shares in a mutual fund, you can profit from not only the price gains of the individual stock but also from the dividends the corporation distributes to its shareholders. The price of the stock in the fund determines the value of the mutual fund, which means that the price can fluctuate heavily based on circumstances! The advantage is that because the fund is invested in different stocks, the loss in value of one can be offset by positive development of another stock.

Bond funds invest in interest-bearing securities such as government or corporate bonds. These issuers (that is, the companies and government agencies) issue bonds to borrow money, perhaps to pay for new investments. Whoever buys securities from them receives interest (regularly, at that) in return for the loan. These regular interest payments are also the reason bonds are under the umbrella of what are called debt securities.

Depending on the investment strategy, a fund that buys bonds can have different focuses, such as a certain country or region, currency, or term. Alongside “normal” bond funds are what are known as target maturity funds, which have a predetermined term, usually somewhere around five to seven years.

The money market is that part of the financial markets where the demand for money and the supply of money come together. Banks, companies, and government agencies borrow money there on the short term – or even make it available. Thus, money markets primarily trade in short-term securities such as overnight, one-month, and 90-day loans. This is precisely where money market funds invest. They buy interest-bearing securities with a short remaining time to maturity and – just as you probably guessed – get interest on them. The principle is the same as when you borrow money from your bank and pay interest on it. It’s just the other way around – the fund plays the role of the bank, and the government or the large company plays yours. It’s precisely this interest that then yields the return on the money market fund. However, they are particularly suitable for you as an investor if you want to set money aside and leave it be for a very short period of time. Now, the interest rates in this domain are…basically zero right now.

An open-end real estate fund buys different properties with its investors’ money. It invests, for example, in apartment or office buildings, hotels and shopping centers, or logistics real estate. In return, the fund receives rental income, and it profits from the increase in value of the properties held.

Commodity funds allow you to participate in the development of the international commodity markets. It’s quite practical, because there are a lot of super important commodities that you couldn’t trade yourself for legal or logistical reasons. Even a commodity fund often can’t do this directly and therefore generally uses a derivative to invest.

Derivatives are financial products whose price comes from a so-called underlying asset. This underlying asset can for example be the stock of a certain company or a fixed amount of a commodity (e.g., a barrel of crude oil or a bar of gold).

You can picture the derivative as a contract drawn up between buyer and seller. To put it in very simple terms, this contract states that the seller will deliver the barrel of crude oil to the buyer at a later time, albeit one that has already been determined by this point (e.g., in three months). The price the buyer pays the seller for it has already been set in stone in the contract.

Commodity prices often develop completely independent of investment forms like stocks and bonds, which makes it easier to spread the risk out more broadly. Many commodity markets are pretty small, though, so a change in the supply or demand situation can swiftly affect prices. Large price swings result from this, leading to that same effect on both the fund and its shares. Additionally, the price development of commodity markets often depends directly on the international (political) situation.

Last but not least: Hybrid funds invest in several different asset classes, such as stocks, bonds, money market instruments, currencies, or commodities. Depending on the composition and weighting of asset classes, a fund manager can generate profits across very different markets…and they can compensate for an asset class that’s not doing so hot. For instance, if stock market prices decline, they can invest more heavily in bonds to mitigate losses.

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