How to choose an investment fund?

You will find primary information about the investment policy of a fund in the fund prospectus. You should definitely consider the information about the yield expectations of the typical investor of the fund and the description of its risks.

However, the information in the prospectus is rather general and gives the fund manager relatively free hands in changing the investment principles whenever necessary. For example, the Swedbank Eastern European Equity Fund invests mainly in small companies, but according to the prospectus it is not prohibited for the fund to also invest solely in the shares of big companies. At the same time, this would change the risk level and expected rate of return of the fund quite significantly. Make sure you read the cost review of the fund as it gives you a good overview of how the fund managers make their investment decisions. The cost review contains information about the biggest investments of the fund as well as the division of the portfolio according to countries and securities.

The analysis done by the well-known investment rating agency Morningstar shows that investors, who invest in the same fund for a long time, usually for at least a couple of years or longer, are the most successful.

What are the risks associated with the fund?

The historical rate of return graph of a fund gives the best picture of how risky the fund is. If the price of the fund unit has fluctuated more than the price of the units of other funds in the past, then it may be presumed that it will do the same in the future.

Conclusions about the risk level of a fund can also be made on the basis of the standard deviation that shows the average fluctuations in the price of the fund unit in the past. For example, the standard deviation in the rate of return of the Emerging Markets Equity Fund of JP Morgan Funds within the last five years as at 31 March 2007 was 17.25% and its rate of return in the same period of time was 26.8%. This means that the annual rate of return of the fund was an average of 17.25% higher or lower than the annual average (28.8%) or either 8.75% or 44.05%.

Some risks are not reflected in the earlier behaviour of the fund unit. Assessment of such threats is of course extremely complicated and there is no miracle formula here – the only remedy is sufficient dispersion of investments or investing in different regions and asset classes.

Who manages the fund?

Once you have found the fund whose risk level and investment policy are suitable, you should also check who manages the fund. Even though several people are generally involved in the management of a fund, the success of the fund ultimately depends on the fund manager.

There are basically four fund management models:

• sole management – one person is responsible for the management and everyday activities of the fund;
• team-based management – several people manage the fund, and one of them may be the official fund manager;
• management with several managers – the asset classes of the fund have been divided between several managers, and each of them manages their own area;
• outsourced management – everyday fund management is outsourced from another asset management company.

The team-based management model gives an advantage in the situation where the fund manager leaves.

What are the costs of a fund?

Four types of costs must be considered when investing in funds: transaction costs, unit issue and redemption fees, management fees and depositary’s charges.

• Management fees and depositary's charges – payable for everyday management and administration of the fund, which are deducted from the net asset value of the fund unit on a daily basis and not paid by the investor directly from his or her current account. Management fees and depositary’s charges are also deducted from the net asset value of the unit when the rate of return of the fund is calculated.
• Unit issue and redemption fees – these are usually paid to the agent of the fund, who advises investors and helps them choose the fund. For example, Swedbank is the agent for Swedbank Investment Funds, JP Morgan, T. Rowe Price and Franklin Templeton funds. Issue and redemption fees should exclude short-term speculation with funds.

You will find the rates of management fees, depositary’s charges, unit issue and redemption fees in the prospectus. The exact amounts of fees and charges are given in the terms and conditions of the fund, which are always an inseparable part of the fund prospectus. According to the Investment Funds Act, the terms and conditions of a fund must always give the upper limit that the fees and charges (management fees, depositary’s charges, transaction fees payable when trading with the securities in the fund portfolio, etc.) must not exceed.

How to choose an investment strategy?

An informed choice of a strategy means you can stay calm and not make rash, incorrect decisions at the time when stock markets are volatile.

The most important thing to do when you start investing is to clarify the goal of your investments. In general, goals can be divided in three:

1. maintaining the value of the investment,
2. achieving a rate of return that exceeds inflation,
3. earning the highest possible income.

Risk and rate of return go together

It is impossible to set earning the biggest possible income as your goal and be safe in the knowledge that the value of your investment is not going to drop at some point. It is highly likely that the funds or shares that increase the most when the market is on the rise will also lose the most of their value in the event of a decline.

The risk level of an investment can be assessed with standard deviation, which shows the average deviation of the fund unit’s rate of return from the average.

For example, the rate of return of the Swedbank Russian Equity Fund since the creation of the fund was, as of 30 June 2007, 8.4% and the standard deviation of the annual rate of return of the fund was 24%. This means that the probability of the fund staying between 15.6%-32.4% or one standard deviation from the average rate of return is 68%. Such a large fluctuation interval shows that the Swedbank Russian Equity Fund has a very high risk level.

The average annual rate of return of the Europe Aggregate Plus Bond Fund of JP Morgan Funds as of 30 June 2007 was 4% and the standard deviation of the rate of return over 5 years was 2.87%. This means that with 68% probability, the rate of return of the fund will remain between 1.13%-6.87%, which means that the risk and possible fluctuation of units in this fund is considerably lower than in the Swedbank Russian Equity Fund. You will find information about the standard deviation of a fund in the monthly report of the fund, if the history of the fund is long enough for calculation of the standard deviation.

Standard deviation reflects both increases and decreases, but investors are mostly interested in decreases when determining the risk. You can assess the risk of decrease when you analyse the historical rate of return of the fund. A security that has gone through decreases that exceed the market average will also remain riskier than the market average in the future.

You can also determine the risk level of a fund’s strategy according the share of equities and bonds in the fund. Funds that invest 100% in bonds have the lowest risk level whereas the risk level is the highest in funds that invest 100% in equities. The same applies to the rate of return – it tends to be very stable in bond funds (when we exclude funds that invest in high yield bonds) and rarely negative. The rate of return of shares has historically been higher than that of bonds, but those who invest in stocks and shares and in equity funds must also keep in mind that relatively big decreases are possible.

Select the share of equities and bonds according to the investment period

You can manage the risk arising from stock market fluctuations when you invest for a long term. It is not important what the portfolio does in between as long as the biggest possible amount is earned in the end. This means that long-term investors can afford to ignore short-term decreases. Dimson, Marsh, Staunton studied the behaviour of stock and bond markets from 1900-2005 and found that equities have underperformed bonds every third five-year period. At the same time, the longer the investment period, the least likely it is that the rate of return of shares is lower than that of bonds. This is why investors are advised to consider equity funds when they plan to invest for at least five years, balanced funds should be considered in the event of a 3 to 5-year period and bond funds when the investment is made for 1 to 3 years. Of course, you can always be more conservative with your investment than the period would permit, but the risk in this case is that you may not earn much.

Summary

• Think about the goal of your investment.
• Analyse how different strategies would suit your goals.
• Check that the strategy is suitable for your investment period.

How to read fund reports?

You can get a detailed overview of the activities of a fund from the monthly report or factsheet of the fund. The monthly reportss of different management companies are different, but they usually contain the general data of the fund (asset volume, net asset value of units, data about the management company and fees, comparability index), comments by the fund manager, division of the portfolio according to countries, currencies and economic sectors and a list of major investments.

1. Investments according to economic sectors

   It is important to observe the share of different sectors in different equity funds. A fund that invests on a relatively large scale into just a few economic sectors can offer an excellent rate of return when such sectors are doing well, but should the economic climate change for the worse, they may fall behind funds whose portfolios are dispersed better.

   For example, the Swedbank Eastern Europe Equity Fund has invested a very large part or 48.3% of its portfolio into the financial sector as of 30 June 2007. Such a strategy may prove to be correct as Eastern European countries are going through a phase of fast economic growth, which is accompanied with a fast growth in loans. Banking was also the biggest sector in the portfolios of other Eastern Europe funds with 32.56% in the Templeton Eastern Europe Fund and 28.9% in the JP Morgan Funds Eastern Europe Equity Fund. The two biggest sectors together formed almost 60% of the portfolio in these three funds, or all funds preferred to invest into the same economic sectors in Eastern Europe.

2. Geographic break-down of investments

   The geographic allocation of the portfolio also reflects its risk concentration. In addition to the so-called traditional Eastern Europe, both JP Morgan and Templeton Eastern Europe funds also invest a large part of their portfolios into Russia: JP Morgan 66.1% and Templeton 22.57%. The large share of Russia means that the risk level of these funds differs significantly from that of the Swedbank Eastern Europe Equity Fund. The investments of the Swedbank Eastern Europe Equity Fund are concentrated on the Balkan region with 60% of the fund portfolio invested in Bulgaria, Romania and Serbia. This means that if the reforms in Balkan countries and their integration into the European economic sphere are successful, the fund could achieve excellent results whilst if the opposite happens, there is the threat that the fund will do worse than its competitors who have dispersed their portfolio better between different regions.

   There is another risk that arises for investors from the geographic division of the portfolio – the currency risk (exposure to different currencies has been brought out separately in the reviews of some funds). A fund can manage currency risks and the relevant policy may be described in the prospectus, but fund managers are often left with rather free hands in this matter. Studies generally show that management of the currency risks of an international equity portfolio does not change the risk profile of the portfolio too much, but it does reduce the risk level of bond portfolios.

3. Major investments

   A complete list of the fund’s investments that gives a detailed overview of the dispersion of the portfolio is available at different rates in different management companies. The full list of the Swedbank Eastern Europe Equity Fund investments is published once a month with a two-month delay. The ten biggest investments of the fund as of the end of the previous month are usually published in the monthly reviews of funds. This allows conclusions to be made about the fund’s investment policy rather well.

   For example, in the Templeton Eastern Europe Equity Fund, the ten biggest investments formed 58.92% of the fund portfolio, in the JP Morgan fund 53.5% and in Swedbank Eastern Europe Equity Fund 46.1%. This means that when compared to others, Templeton invests in a relatively smaller number of shares, which may either improve or deteriorate the fund's rate of return depending on how well the companies do.

4. Duration of a bond fund portfolio

   The risk level and potential profitability of bond funds can also be assessed according to the duration of the fund's bond portfolio. Basically, duration shows the length of time during which the borrower makes payments to the lender. For example, the duration of a short-term bond whose interest and principal are paid back at the same time after six months is six months. Bonds of longer duration are riskier, because when interest rates rise, their prices drop more than the prices of short-term bonds. The reason for this is that after interest rates rise, investors no longer wish to buy bonds that are earning less interest at their former prices and these bonds must become cheaper in order to make their rate of return competitive again. For example, a bond fund whose average duration is eight years loses 8% of the value of its portfolio if interest rates rise 1%. The weighted average duration of the significantly less risky Swedbank Fixed Income Fund, which can be found in the general data part of the fund review, was only 216 days as of 30 June 2007. This means that the fund portfolio would lose 1.5% of its value if interest rates rose by 1%. A 1% rise in interest rates is extremely high in the European credit markets and would definitely not happen overnight.
   

5. Credit rating of bond portfolios

   Another important indicator in the assessment of the quality and risk level of a bond portfolio is its credit rating, which shows the strength of the creditor’s ability to repay the loan with interest. Three big agencies in the world give credit ratings to bonds: Standard & Poor’s, Moody’s and Fitch IBCA. The markings of their ratings differ somewhat, but the general principle is the same – according to their rating, bonds divide into investment grade and high yield bonds. The latter are also known as junk bonds.

   Moody’s ratings of bonds have been given in the Swedbank Fixed Income Fund monthly report. The average rating of the portfolio can be found in the general data part of the review and it is A, which denotes investment grade bonds. The review also contains a division of the portfolio according to ratings, which shows that as much as 90% of the fund portfolio has been invested in investment grade bonds and less than 10% in high yield bonds.

6. Market commentary

   Even though market commentary is rather concise, it does provide information about the fund manager’s opinion of the current situation in the market and the most important changes in the portfolio. However, buying or selling units solely on the basis of the market commentary should be avoided and investors should remind themselves of the goal of the investments they have made. Even if the fund manager believes that markets are currently overvalued, this does not necessarily mean that the investment is a bad one in the long run.

Summary

Even though it pays to review the fund prospectus and the terms and conditions when investing, it is also recommended that you read the monthly report of the fund. Monthly report allows you to decide whether the fund manager continues to follow the same strategy or whether significant changes have occurred in the fund, which could change the risk level of the fund and give you a good reason to review your investment portfolio.