Oran Hall | Collective investment schemes aren’t risk-free

It is easy to believe that collective investment schemes, being diversified and professionally managed, expose investors to little or no risk.

Market developments over the past two or three years illustrate that even they are sensitive to economic and market conditions. They offer investors no guarantees.

Collective investment schemes are arrangements in which many investors pool their funds, which are managed by professional investment managers for their benefit, the managers themselves earning an income for their efforts.

Unit trusts and mutual funds are examples which the public has ready access to, but there are similar arrangements, such as segregated funds, which life insurance companies offer exclusively to their policy-holders who subscribe to particular types of policies that they offer. They are called segregated funds because they are not commingled with the funds of the insurance companies.

How well mutual funds and unit trusts do depends on the investment policies and strategies of the entities that manage them as well as on the competence of the people they hire to manage the funds, and the systems in place to support the process.

Current market conditions affect how the various investment funds – or investment portfolios – perform. It is because investors have varying investment objectives and tolerance for risk why it is necessary to have different kinds of portfolios. Thus, there are money market funds for the risk-averse investors and capital growth funds for investors with a greater appetite for risk.

But these types of funds come in several forms. Capital growth funds sometimes come as equity funds, or real estate funds, but they might also come as mixed funds, sometimes called blended funds, made up of assets from classes, such as equities, real estate and bonds.

As we have seen in our market, interest rate movements have the ability to upend almost every type of portfolio. When interest rates increase, they tend to cause interest to shift from the equities market to the market for bonds and the money market. High interest rates tend also to affect the profit of businesses negatively, and thus the stock market. Portfolios focused on stocks consequently tend to experience a decline in their performance.

High interest rates also tend to affect the real estate market negatively, so this extends to real estate funds and blended funds that invest in it.

Should bond funds not then do well when interest rates increase? To the extent that new funds are invested in the higher-yielding bonds, there is some gain to the funds. But what about bonds already in the portfolio? Higher interest rates are bad for them. The reason is that there is an inverse or indirect relationship between interest rate movements and bond prices. Thus, bond prices fall when interest rates increase and vice versa.

Changes in bond prices affect the value of the instruments as well as the value of the portfolio and unit prices in the case of unit trusts and the value of the shares in the cases of the mutual fund. What is clear is that it is not necessary to sell a bond for it to affect the portfolio.

The type of fund that should be least affected negatively by interest rate movements is the money market fund that is true to its name. Any change is not likely to be dramatic as the value of money market instruments should not change much, if at all, in response to interest rate movements. In cases in which interest rates decline the proceeds from securities that mature will be re-invested at a lower rate.

I doubt there is a pure investment fund, meaning one that invests exclusively in assets that its name suggests it should invest in. So, for example, equity funds may hold interest-bearing securities, and money market funds often hold bonds.

Collective investment schemes do not offer guarantees. They are not customised. They cannot be all things to all men. Investors should educate themselves about any type of investment vehicles they intend to invest in. Caution is the word.

Investors should not take for granted that the name of a fund says accurately the instruments it invests in. It is useful to read the offering circular, also called the prospectus, or the offering document, to become familiar with the stated philosophy of the unit trust or mutual fund, the investment objectives of each fund, and the types of instruments in which it invests.

If satisfied, they might wish to proceed, but bear in mind that it might be necessary to invest in more than one fund and more than one collective investment scheme, not just for diversification purposes, but to improve their chances of meeting their investment objectives.

Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com