Last week we began a beginning investor series on balanced mutual funds. What they are, how they work, and where they are available in Bermuda. (See Balanced Mutual Fund Options in Bermuda, http://www.royalgazette.com/article/20150117/COLUMN07/150119761).

Year-end reporting for the balanced mutual fund products is still about another week away — as not all Bermuda investment providers listed last week have posted final fund statements for the year end 2014 to their websites. So, we will wait a couple more weeks to delve into the performance of these funds.

Instead, that leaves us with the exciting opportunity to honor another reader’s request. “Where can I purchase a low-cost index mutual fund in Bermuda?”

This is a perfect time to compare the similarities and differences between a balanced mutual fund (actively-managed) and an index fund (passively, almost non-managed). Or, why on earth would this rather obscure subject be considered interesting?

Very easy answer.

Passive mutual fund fees that track the performance of an index are very low, generally, when compared to actively managed funds.

Why? Once the index is set up — by buying each of the stock positions on the index in the same approximate proportions, the shares just sit there in the fund. The share values move up and down in tandem with the index the fund emulates. Index fund managers track the performance on a monthly basis and issue the results. This is an oversimplification, granted, but generally, there is much less management involved, so the cost of running the fund is quite low.

Actively managed mutual funds charge fees, higher fees, to manage the mutual fund portfolio. Whether the fund contains a group of stocks, say of large cap giant multinational companies or a group of corporate bonds or a balanced percentage mixture of 60 per cent stocks, 40 per cent fixed-income (bonds) such as our example, the portfolio manager must manage those mandated proportions.

How is this accomplished? Through the concept of rebalancing. Portfolio managers do earn their keep because the mandate of an actively managed mutual fund (or an individual portfolio) is to rebalance the security positions within the portfolio on a routine basis.

First example: Consider a balanced mutual fund where the equity stock allocation (total 60 per cent) consists of 30 per cent US stock positions and 30 per cent European stocks. We all know that US investment markets stock values have exploded, while recently European stock values have tanked. Now, your equity section is say 45 per cent US stocks and only 15 per cent Euro stocks by value. What’s wrong with that? Well, a lot. What happens if the market suddenly swings in reverse?

A prudent seasoned investment manager — at the appropriate time (and contrary to actions you would even consider) will be trimming off those excess US stock profits and reinvesting in what you would think as the loser economies of Europe.

Why? Because that is the rule of rebalancing — known as strategic asset allocation according to Investopedia — and is also mandated according to the balanced fund investment policy statement set-up at inception of the fund.

Naturally, it is assumed that the entire group of securities are selected for their excellent investment qualities, first. Mutual fund portfolio managers also use tactical asset allocation that allow for ranges of percentages, say 55-65 per cent equities for further management flexibility.

We almost subliminally understand that capital markets are unpredictable. Think oil and the Swiss uncoupling their currency. In an instant, markets changed. The securities previously un-dervalued will rise while the high-flyers take a plunge. Meanwhile, investment managers have already taken profits, and rebalanced to the undervalued for smoothing, disciplined investing.

Second example: Let’s use the passive S&P 500 Index fund that approximates the S&P 500 index (GSPC, a globally recognised benchmark for 500 stocks of very large United States companies.)

In 2007, the S&P 500 Index price (Source: Yahoo! Finance) ended the year at 1,468.36 (contrast that with year end 2014 at 2,058.90), then 2008 appeared — a horrible market crash - year ended plunging to 903.25. This represented a 37 per cent loss! At 2009 year end, the S&P at recovered somewhat, up to 1115.10.

So passive index funds are cheaper, but require a temperament to stay invested for the long-term. If, you were remained a fully invested stalwart — note again that S&P Index value gain! at year-end 2014 — from 903.25 in 2008 to 2,058.90, six years later!

Individual investors so often cannot bring themselves most of the time to trim off the winners and reinvest in the undervalued securities. Nor simply stay the course long-term. We suffer during capital market investments roller-coasters and eventually end up selling — at a loss.

If you are that type of investor, then comfort and some stability is what you pay for (in fees) to the balanced fund portfolio managers. The balanced fund will, generally, not reflect those massively high valuations or those terrible losses. Yes, there are exceptions — discussion next time.

What passive index mutual fund products are available in Bermuda?

AFL Investments Ltd offer five RAFI Index funds — listed on their website. Barrington Investments, as as broker, offers a Vanguard ETF Index fund and possibly others. Butterfield Asset Management, through their self-directed brokerage account, may offer index funds — contact to ascertain. LOM Investments offers Fidelity and Schroder Mutual Funds through their self-directed brokerage accounts — a large selection so an index fund should be included. Contact to ascertain and review lists on their website. BIAS Investments offers a self-directed brokerage account that may offer index funds. Contact to ascertain various products.

Caution: US citizens, Bermuda residents with green cards, and US tax residents (foreign nationals who have overstayed in the US) cannot invest in Bermuda (foreign) mutual funds. Speak to your tax accountant as to the serious reasons why these are prohibited.

Further, all experiences investment professionals will no doubt immediately realise that this information is old hat for you. That is because this series intends to encourage beginning investors to plan for the future.

Investment disclosure. Finally, you know the drill. This investment article is general education information only. I am not your adviser and you cannot rely upon the information provided in this article — for your personal investments. Consult a qualified investment professional.

Martha Harris Myron CPA CFP JSM Masters of Law: International Tax and Financial Services, appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland; president of The Pondstraddler* Life™ Consultancy: international financial planning, publications, presentations for the challenging lifestyles of multinational individuals and their families residing, working, crossing borders, and straddling ponds in the North Atlantic Quadrangle. Specific focus for residents of Bermuda, the premier international finance centre. Contact: martha@pondstraddler.com