Investment Encyclopedia

Dollar Cost Averaging

Employees participating in the Mandatory Provident Fund system may be worried that the investment returns of their MPF contributions would be adversely affected when the market environment is volatile or when the investment conditions are not good. In reality, the risk level of MPF investments may not be as high as they think. Why?

Although market ups and downs may affect the performance of the funds, MPF is such a long-term investment that the short-term fluctuations would become less substantial when the length of the whole investment period is taken into account, say 10 years or more. Moreover, contributing regularly in MPF can generate the effect of Dollar Cost Averaging which will benefit the members in the long run.

What is Dollar Cost Averaging? How can MPF members benefit from it?

Dollar Cost Averaging is the method of investing regularly with a fixed amount in a long-term period. Making monthly MPF contributions is a good example. By investing a fixed amount regularly, you buy more fund units when the prices are low, and buy less when the prices are high. As a result, the overall average cost of units can be lower than the average unit price over the investment period. The fluctuations of market prices could be evened out in the long run by averaging the costs of investment. Therefore, investing regularly in MPF would therefore provide you with the benefit of Dollar Cost Averaging while minimizing the adverse effects brought about by market volatility.

In order to better leverage the advantages of Dollar Cost Averaging, it is always wise to invest in the same portfolio consistently without frequently switching funds. The longer the investment horizon in the same portfolio and the larger the volatility, the greater the effect of Dollar Cost Averaging would be on your investment.

Let's look at an example. Assume that you contribute $1,000 monthly and the investment period is 12-month.

As shown above, the average unit cost of your investment $12.38 and the average unit price is $12.42. The average unit cost is $0.04 lower than the average unit price and your investment return is $1015.55 by the end of your investment period. This has well demonstrated the effects of Dollar Cost Averaging.

Below we will look at another example by referring to the investment of an MPF member of the Principal S800 Master Trust Scheme. Let's assume that the member contributes $1,000 per month in the funds from December 2000 to September 2004. The details of the investment are as follows.

Most of the members would only look at the point-to-point investment return of the funds (as shown on the last column) and would be worried when they find some of the returns negative. Their MPF investments may be, however, earning positive returns. Referring to the example above, we can see that some of the Actual Investment Returns are, in fact, positive despite that the Point-to-Point Investment Returns are negative.

Actual investment return indicates the amount you actually gain or lose during the whole investment period (i.e. 12/2000 to 9/2004) while point-to-point investment return is the change in fund prices by comparing the current fund price (i.e. as at 30/9/2004) to that of the point of reference, which is 29/12/2000 in this case.

Unlike the case of lump-sum investments, as MPF is contributed monthly, it would be misleading if we just look at the point-to-point returns of the funds. Comparing investment returns point-to-point may not reflect the true picture as it does not take into account the Dollar Cost Averaging effects. Therefore, MPF members should not only focus on the point-to-point investment returns and need not worry too much about market fluctuations in the short-term as the Dollar Cost Averaging effects help you to even out the market ups and downs in the long-run.

Capturing Investment Opportunities in the Bond Market

In the last few years, low interest rates and economic uncertainties have prompted capital to flow from equities to bonds in the investment sector. Supported by these factors, the bond market has been bullish for a number of years. Now, as the economic tide turns, many investors believe that the loosening cycle will come to an end even if US rates remain low this year. With the consensus of rates trending up, bond yields are expected to rise while bond prices are set to fall. Although the golden age for bonds has passed, it does not mean that investors have to cut holdings of investments in bond funds or balanced funds.

As a matter of fact, rate movement is only one of the many factors that impact the investment return of bonds. Fund managers can use certain strategies to enhance return of bond funds.

Although credit spreads (difference between yields of government and corporate bonds) have tightened considerably, lower grade bonds, particularly high yield classes, are still attractive. Fund managers can select quality issuers with improving outlooks and room for further spread tightening.

On the other hand, fund managers can choose to buy Treasury Inflation-Indexed Securities (TIPS) (also called Treasury Inflation-Protected Securities) to enhance investment returns in an environment of inflation. The nominal principal of this bond is adjusted according to the latest consumer price index published. Since the coupon rate is based on the principal, it is in effect pegged with inflation1. While conventional bonds perform negatively when inflation sets in, this inflation protected bond goes up.

Moreover, exchange rate movements will continue to bring additional returns to bond funds. As in 2003 and 2004, US dollar is expected to remain weak against major currencies in the coming year which is caused by the twin deficit problems of the budget and the current account. Euro bond funds seem like a good choice.

Over a longer term, the bond market will see less volatility than the stock market. While the consensus is that equities will outperform bonds, the market is an ever-changing place. In particular, upcoming elections in the US and Asian countries will inevitably create political volatility. In such uncertainties, bonds are key elements for balancing a portfolio, and are especially important to long-term investors.

¹ Source : Financial Analyst Journal, Volume 60 No. 1

How to Choose a Fund: Analysis of Past and Future Performance

When choosing investment managers, many investors focus on the their past performance. To most people, managers with the highest rates of return are the best. The truth is, choosing a fund is like choosing a stock. In addition to past performance, one needs to examine the future outlook. When one considers buying a stock, one would need to study the company's business development prospects and management approach, in addition to its past results. This rule applies to fund selection as well.

When selecting a stock, one needs to understand the company's business nature. Likewise, it is also wise to know a fund portfolio's scope of investment. Different funds classified as Asian Equity Funds may have quite different asset allocations. Some may include regions like Australia and New Zealand, while others include only in Asian countries. Some mainly invest in China, Hong Kong, Taiwan and Korea, and others have balanced exposure in North Asian and South Asian markets. Despite the general classification of Asian Equity Funds, these funds can vary greatly in return and volatility.

When analyzing the profitability of a listed company, you have to understand its growth momentum and predict whether such growth is sustainable. This is also true when you analyze the return of a fund. You have to draw an informed conclusion about whether a fund manager is outperforming purely by luck or professional capability by reviewing past records. Some fund managers will even reveal reasons for outperformance or underperformance in their investment reports. The longer the fund manager can maintain outstanding performance, the clearer the fact that he/she possesses superior investment expertise.

Personnel changes in a company's management often cause concern. Similarly, fund manager replacements should be taken seriously enough. Sometimes a fund's impressive past records are attributed to the personal excellence of a fund manager who has left the company. Therefore, it is recommended to learn more about the fund manager before buying a fund with outstanding past performance. You can consult the sales representative or call the fund company for further information.

Listed companies which are popular among investors often have strong management teams. Can you remember how some listed companies invested in the I.T. sector blindly during the I.T. craze? Some fund managers made the same mistake. By referring to the investment reports, you can understand the fund manager's investment philosophy, market speculation, preferred sectors and investment strategy. Not only does this help investors choose a suitable fund with an investment principle that you agree with, it also provides enough information for investors to avoid holding funds of similar strategies to diversify investment risks.

In the explanatory memorandum of each fund, you will find the declaration of "past performance is not indicative of future performance". Prospective investors should always remember this golden rule. As in choosing a stock, an investment decision on fund selection should never be based solely on past records.

Is Choosing a Fund Easier than Choosing a Stock?

The equity market has posted significant gains in recent months. Boosted by this encouraging performance, investors are returning to the market. The most direct way of participation in the investment market is to buy shares listed on the Hong Kong Exchange. While buying low and selling high is every investor's goal, this may be hard to achieve if one does not dedicate time and efforts fully. It is onerous and time consuming to analyze the fundamentals of more than 1,000 stocks, and to pick out the ones worth investing in. Factors like business outlook, financial performance, management quality, gearing ratio, expected dividend rate and valuation have to be taken into consideration, and the timing of buying and selling must be well controlled. This is not easy even for full-time investors, not to mention the busy Hong Kong people who have pressing work schedules and frequent overseas trips.

As a result, many investors tend to buy funds instead. It is indeed a good solution as the fund managers will take care of all investment issues and explore market opportunities around the world. There is also an added benefit of reducing risks through diversified asset allocation. However, is choosing the right fund really a piece of cake and so much easier than buying stocks directly? What is there to look out for?

At present, there are nearly 2,000 Securities and Futures Commission ("SFC") authorized unit trust funds and mutual funds trading in Hong Kong, even more than the number of stocks listed on the Hong Kong Exchange. Based on the investment vehicles they use, these funds can be classified into ten major classes: bond funds, equity funds, diversified investment funds, monetary market funds, index funds, guaranteed funds, hedge funds, umbrella funds, fund of funds and other specialized funds. They can be further broken down by geographical region and sector, such as global, regional, single market and theme funds. Investors should first understand these fund classes, and systematically analyze the features of every fund under consideration. In this way, it is not difficult to pick a fund that meets your personal requirements. The following is a three-step aid for fund selection.

The first step is to gather information on different regional markets, such as recent economic data and market outlook released by different investment institutions. This is followed by analysis and comparison of these data to decide on the most suitable investment products and regions. For example, the US economy began to recover in the second quarter of 2003. This strength is expected to benefit the high growth and export driven Asian economies. At this particular time, investors can consider buying US and Asian equity funds.

Upon choosing the investment products and regions, the next step is to identify a quality fund. Quantitative analysis is a common means of selecting the right fund. Quantitative data include past performance records, volatility, beta and Sharpe ratio. Since the accuracy of all statistical analysis depends invariably on adequate data, data from the last three years are taken into account in most cases.

Many people base their fund choice purely on records of past performance. This can be dangerous. Let's take a look at a real life example. Bond funds have recorded positive returns in the last three years while equity funds underperformed. As economic growth gathers pace, investment capital will gradually flow from the bond market to the equity market. A smart investor should seize this opportunity and reallocate funds to the stock market. Not long ago, banks and investment advisors lured investors with impressive performance records of bond funds, and many were attracted. Some investors also made a mistake of buying at peak levels because they thought bond investments involved much lower risks. In mid June this year when bond yields bounced sharply, these imprudent investors became victims of a mini bond market crash. They learned the hard way that "past performance is not indicative of future performance".

The last step is to carry out a qualitative survey to understand the strategy of a particular fund and the investment approach of the fund company. Funds of any given class may vary greatly in performance because their investment approaches and strategies differ. For example, a value fund is focused on equities that offer high value, while a growth fund emphasizes on high growth potentials.

All in all, it is not difficult to choose a fund that meets your personal requirements. Please bear in mind that advanced research is important and not to follow others blindly. Remember, you have to know what you invest. Hopefully the above suggestions will help you capitalize on investment opportunities under changing market situations.

Long-term Investors' Choice - Balanced Fund

Balanced funds are generally invested in equities and bonds. These funds seek, on one hand, a stable income through exposure in bonds and more aggressive capital growth through exposure in stocks on the other. To long-term investors, particularly pension scheme members who do not wish to switch funds frequently, a balanced fund seems to be a good choice that offers the benefit of diversification.

Given that return expectation and risk acceptance level vary with individual investors, there are a wide choice of balanced funds on the market with different asset allocations. Most of these funds allocate their assets in set weightings of equities and bonds. As a general rule, younger and more aggressive investors prefer balanced funds with a high equity weighting, while older investors favor those with a larger allocation in bonds. In selecting balanced funds, while weightings of equities and bonds are important, investors should also give consideration to geographical, currency and sectoral allocations.

If a balanced fund invests mainly in the Asian region, it may be exposed to higher stock market volatility than in developed countries, and ratings of bonds in the portfolio may be relatively lower. As such, the overall risk level is higher than a global fund.

A fund that invests in many regions of the world can diversify investment, but there is inherent risk of exchange rate fluctuations. To reduce the impact of exchange risks on redemption values, some investors would choose balanced funds that invest only in USD and HKD assets.

In addition, bond classes (e.g. sovereign or corporate bonds) and investment restrictions are also important considerations. For example, corporate bonds performed well in 2003 as credit spreads (the interest rate difference between corporate bond yields and sovereign bond yields) tightened. If a fund's strategy only allows investing in government bonds, it would not have benefited from this spread movement. On the contrary, if the bond portfolio contains different classes of issues, or the fund manager can effect rotation between corporate and sovereign bonds flexibly, investors will enjoy return from credit spreads.

In fund selection, while equity and bond weightings are important, the above factors should not be overlooked. Careful selection will help you identify a balanced fund that is best suited in meeting your investment objectives.