When investors invest in mutual funds, portfolio management services or other professionally managed investment products, they are essentially trusting a fund manager to make decisions on their behalf.
But how do fund managers generate returns
A fund manager’s job is to invest the funds of the fund according to the fund’s stated purpose. Depending on the type of fund, that can be in stocks, bonds, government securities, commodities or a combination of all these.
Selecting the Right Investments
One of the most important ways fund managers try to generate returns is through security selection. Equity fund managers, for example, study companies before investing.
They may look at revenue growth, profitability, debt levels, management quality, competitive advantages and future business prospects.
From the perspective of the investment strategy, the goal is to identify investments that appear attractive relative to their current price.
If the value of a company’s stock increases after the fund puts money into the company, then the portfolio can benefit from capital appreciation.
Asset Allocation Matters
Fund managers also decide how much money should be allocated to different asset classes. That is asset allocation, and it can really affect portfolio performance.
For example, a balanced strategy may combine equities for potential growth with bonds for stability and income.
In periods of market uncertainty, the manager may adjust portfolio exposure depending on the fund and investment strategy.
Diversification and Risk Management
Generating returns is only one component of fund management. Capital protection and risk management are equally important.
Fund managers generally diversify investments across companies, sectors, industries or securities. Diversification can lessen the impact of a poor investment on a fund's overall portfolio.
Risk management can also be based on limits on individual holdings, market conditions and regularly reviewing the portfolio. But diversification does not eliminate investment risk or guarantee returns.
Taking Advantage of Market Opportunities
Market dynamics change with the economy, interest rates, company earnings, government policy, investor reaction, etc.
Fund managers monitor these changes constantly to determine opportunities and risks.
Some managers take the long-term approach, holding companies they believe can grow over several years.
Some take a more active approach and sell stocks when their view of a company or market changes.
Compounding Can Boost Long-Term Returns
In addition, another major factor in investment returns is compounding. So when returns generated by a portfolio are reinvested into a portfolio, those returns can themselves generate additional returns over time.
So fund performance is not necessarily about finding one spectacular investment. And good portfolio management over a long time can allow the gains to accumulate.
The Bottom Line
Fund managers can generate returns through research, security selection, asset allocation, diversification and risk management. Their choices can affect how a portfolio performs in the market and in the market’s rising and falling cycle.
But professional management is not guaranteed to produce profits. Investment returns depend on market conditions, the strategy followed, the assets chosen and the risks taken.
To investors, knowing how a fund generates returns is just as important as knowing past performance.
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