Why a Mutual Fund’s Like a Herd of Cattle

Dear Ryan,

I have a unit trust that I track every day. One day it goes up R5.00 or more. The next day it’s lower. I fail to understand how that works. What makes the price change? Say I want to sell my units. What determines the price I will receive?

Sincerely,
Brenda from South Africa

A mutual fund is like a herd of cattle.

Dear Ryan,

I have a unit trust that I track every day.

One day it goes up R5.00 or more. The next day it’s lower.

I fail to understand how that works. What makes the price change?

Say I want to sell my units. What determines the price I will receive?

Sincerely,
Brenda from South Africa

Dear Brenda,

Unit trusts, which are commonly known as mutual funds outside South Africa, are a collection of shares of from many different companies. Every day the stock exchange is open, people buy and sell these shares.

If the news about a certain company is good, the price of its shares will typically rise because investors believe that the company is more valuable than they had previously thought, and demand for the shares increases. But if the news is bad, the price of the shares will often fall. Why? Because the company’s prospects may no longer be so bright, and demand drops as a result.

Owning shares of a company is a bit like owning a cow. If your neighbor sees that your cow is becoming very strong, healthy, and producing a lot of milk, he will probably be willing to pay you a handsome price for it. If, however, he sees that the cow is growing sick or thin, he won’t be willing to pay as much.

If a share of stock is like a cow, then a unit trust is like a herd of cattle. Each individual cow (or share) has its own characteristics. Some are fat. Some are lean. Some are young. Some are old. Some are very productive. Some are not.

Thus, each individual cow has its own unique value. To determine the value of the entire herd (or unit trust), you sum the values of all the individual members of the herd. And because investors’ perception of each share’s value changes on a daily basis, so does the value of the entire mutual fund (or herd).

What is a mutual fund?
Photo by ILRI/Stevie Mann

So, when you sell your units, you will be selling at the price that investors believe the underlying shares of your unit trust are worth on that particular day.

Passive vs. Active Management

Now, let’s stretch this analogy a bit further.

Just like a herd of cattle is overseen by a rancher, cowboy, or herdsman, every unit trust and mutual fund is overseen by a fund manager.

Some ranchers take a “hands off” approach to managing their herds, doing little more than sending them out to graze every day.

But others become much more intensively involved. They nurture the healthiest cows, cull unwanted members of the herd, and search for strong animals to add to the group.

Similarly, the manager of a “passive” fund will trade individual shares infrequently, perhaps re-balancing them once per year. So, the fund’s performance will largely be determined by how the overall market behaves. Some shares will do well, some will not.

An “active” manager, on the other hand, will closely watch all of the shares in the fund in an attempt to maximize performance. He or she will sell those stocks that look like they will perform poorly in the future and use the proceeds to buy shares that they believe will perform well.

Mutual Fund Fees

As you might expect, the fees associated with an actively-managed fund are much higher than the fees of a passively-managed one.

The total expense ratio measures a fund’s total fees as a percentage of total assets. Most of South Africa’s best-performing unit trusts have expense ratios that fall in the range of 1-3%. This means that for every R1000 you invest in one of these funds, you can expect to pay between R10-R30 worth of annual fees. Passive funds will tend to have lower expense ratios.

It’s important to note that actively-managed funds don’t necessarily outperform their passively-managed counterparts.

Why not?

One reason is that high fees are a big drag on performance. The other is that some managers simply don’t know when to leave well enough alone. Because they buy and sell shares frequently, active managers have lots of opportunity to make bad decisions that hurt investors’ returns.

Choosing a Mutual Fund or Unit Trust

How do you decide which unit trust or mutual fund to invest in? I suggest that you compare their performances over the long-term – the past 10 years or more. Look for those that have consistently posted market-beating returns. Consider their expense ratios, too. Why? Because those with lower fees will have an easier time outperforming in years ahead.

Here’s a nice article that shows South Africa’s best-performing unit trusts over the past 10 years to get you started.

Do you have questions about mutual funds and unit trusts? Let’s hear them in the comments!

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8 thoughts on “Why a Mutual Fund’s Like a Herd of Cattle”

  1. This is such a helpful explanation of how investments work. Thank you, Ryan. I feel like I understand a bit more now, and a lot of questions in my head are clear.

  2. Good piece, Ryan. Its a very lay way of explaining the concept of mutual fund investing.

    I have seen this model work well in developing economies like ours where most people have lower disposable income and thus a lower propensity to save. It offers a suitable investment model for risk averse investors.

    1. Great question, Phil.

      I’ve always attributed this to Europe’s closer proximity and its long history as a colonial power. My assumption is that Europeans are better informed of African affairs, while American media coverage of the continent was long fixated on war, disease, and famine. This is changing, however, and I believe Americans’ appetite for African investment vehicles will soon match their European peers.

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