Financial literacy is a key cornerstone in the road to financial freedom. Once you have sorted out your debt and learned how to increase your income streams, the next step is learning how to invest your surplus income so that it works for you, and not vice-versa.
As such, this will be a seven part introductory series on getting started with investing where we break down the different asset classes of investments. We will look at all the different ways we can invest in, such as buying shares, bonds and even cryptocurrencies, then finally on how to build up your portfolio.
This week, we are going to look at something a bit meaty to start us off. It’s an investment we always hear about but very few people actually understand what exactly it is. Welcome to the world of professionally invested funds!
Last week a close friend of mine had asked me for financial advice. She had some cash she wanted to invest with but didn’t know where to put it. She already had a savings account and was looking for a safe place to deposit this little windfall she came across to grow.
After sending out some requests for interest rates, many companies replied to her with fancy terms such as money market funds, balanced funds and equity funds, and she ended up confused at the meaning of all these products. Hence, she wanted to know what the difference between all of these were before making the decision on which one to invest in.
This week, we are going to look at the different types of funds available, the pros and cons of each and how to choose which one to invest in. By the time you are done reading this I hope you will be as confident as her when making your decision!
But before we go any further, let’s start with understanding what a fund is.
What is a fund?
To define it, we can use an example of a chama. When you and your friends or colleagues all contribute money to buy a plot, for example, you have created a common pool of funds being used for a particular investment purpose. That is in essence, what we call a fund.
The type of fund I refer to in this article now invests in financial securities such as shares, bonds and short term securities, making it a diversified investment vehicle.
In the original example, if your group decides to develop the land and maybe put up a two bedroomed structure, you will have the benefits of the rental income and price appreciation of the housing structure and land you purchased. The same applies to any kind of fund- you benefit from its rise in value as well as any interest or dividend payments paid out.
The main difference however between a chama and a fund is that you can easily buy into, and sell out of your position. They are regulated by the CMA and so you can easily trade your fund. This means that if you are in a tight spot (for example a medical emergency comes up), you can easily liquidate it and receive your cash within a day or two. Compare that to the task of selling a house!
Lastly, funds are professionally managed, meaning they charge annual fees (for the expertise and your peace of mind), but remain a great way for individual investors like you and I to get our money working for us.
Now that we understand what a fund is, let’s look at the different types available.
What funds are available in Kenya?
Most investment companies have four types of products:
- Money market funds
- Equity Funds
- Fixed Income funds
- Balanced Funds
- Money market Funds
This is by far the most common one we know of. We see the billboards and banners from all investment companies selling you MMF’s at rates of 9% and so on. But what exactly are they?
Money market funds invest in short term debt instruments like government bonds and bills. Since the government almost never defaults on payments, it mean this is your safest choice when it comes to safeguarding your income.
You would likely earn more than what you’ll get in a savings account but over the long term, less than any of the other funds due to its low risk. Remember, a primal rule in the investing world is the higher the risk, the higher the reward!
- Equity Funds
In sharp contrast to MMF’s, equity funds are mainly invested in stocks found on the Nairobi Securities exchange. This means they are much riskier to invest in, as companies close all the time (think of Uchumi) or have poor records of performance (think Kenya Airways).
As a result, equity funds may not be as popular as the money markets, but there are two major benefits I see in holding them. Firstly, they provide an excellent way of adding shares to your portfolio (which we shall talk in more detail in a future post), without buying them directly.
Stock picking is not an easy concept and if you don’t have the time, would rather pick a basket of shares in the form of an equity fund. You benefit from the expertise of the fund manager as well as gain exposure to dividends and capital gains.
There is also a second fundamental benefit that may not seem apparent at first glance. Transaction costs usually account for 1-3% of the amount you put in when buying and selling shares. This, in addition to brokerage fees and inflation eat into your return on investment. What equity funds essentially do is remove one layer of costs- the transaction fees as you only pay an annual management fee. So that’s some food for thought.
- Fixed Income Funds
These are primarily invested in bonds such as government and corporate bonds. Since bonds pay a fixed rate of return, the work of a fund manager is to ensure they invest in high quality ones that would not default on payments.
Once you are invested in these, however, you get interest payments. You can also make capital gains although this is not the primary focus of FI bonds.
- Balanced Funds
Balanced funds form a combination of the money market, equity and fixed income funds. They are also known as asset allocation funds as they invest in shares, bonds and short term securities in different allocations.
The ratio of investment in each asset class will determine the risk (i.e. the higher the investment in equities the higher the risk), but the idea is that it remains to be the most diversified fund (this does not mean it is the least risky– MMF’s are the least risk funds).
Now that we have examined each type, the question remains, which one should I invest in?
Choosing a fund
To answer this question, I look at three criteria,
- Risk appetite
This is your first point of call. You need to understand how averse you are to risk before you can choose a fund. Most companies will give you a risk assessment questionnaire to gauge your understanding of the risks involved in investing.
Risk depends on a number of factors such as your time horizon, needs for the cash and general risk appetite. Do you have a long term goal you are saving towards, perhaps for your children’s university fees or retirement? Or maybe yours is a more short term goal like saving for a holiday at the end of the year.
Knowing this helps you be clear on whether you are investing for long term capital gains or to keep your money safe but growing for a short period.
If you are a risk taker like me, you will probably find yourself taking and equity or balanced fund due to the allure of high returns. However, if you are closer to retirement age or are looking to safeguard your nest egg, a less volatile product would be more suitable such as a money market fund. The returns may not be as high but you will have peace of mind that you are not going to risk all your money.
Each person has a different risk tolerance and the best investor knows him or herself best before buying into a fund.
- Management Fees and Performance
Remember you are investing for the financial benefit. Hence, when choosing a fund you need to be mindful of the transaction fees associated with an account.
Higher fees do not always mean a better performing fund manager and you should also be wary of those companies whose deals are too good to be true, but the general rule is that you want the fund manager with the lowest fees.
Additionally, while historical performance may seem like a good factor to base your decision, they do NOT guarantee future results.
What you should look at however is how the fund was managed. Ask questions like their consistency in results and their trends. Do not fall for the sales show but instead find out if the fund is growing in size, the manager’s philosophy and ask for their reports that show how market trends affect their performance.
- Due Diligence
This is the last, but arguably most important one. Every fund, be it a money market, equity, fixed income or balanced is regulated by the Capital Markets Authority (CMA). Always conduct research on the company you are looking to place your funds in to make sure you are investing in a legit firm that won’t run away with your money!
So that’s it for the different types of funds. Now that we have a better understanding of what they are, their risks and rewards and how to go about choosing them, I hope you are confident enough to get started in investing in one.
Thank you for reading and happy investing!