Investment funds are an alternative to making direct investments in stocks, bonds, or other asset classes. There are several advantages to investing in funds, as well as one or two drawbacks. In this post we explore the most common types of funds and the pros and cons of investing in them.
- What are investment funds?
- Important investment fund terms
- How do investment funds work?
- What are the different types of investment funds?
- Investment funds vs. direct investments
- Characteristics of a good investment fund
- Pros and cons of investment funds
What are investment funds?
There are lots of different types of investment funds, all with their own unique characteristics. The feature they do share though, is that investment funds always pool capital from multiple investors, and the capital is managed according to a predetermined set of objectives.
There are several immediate advantages to pooling capital in this way. Firstly, it allows for the buying and selling of investments to be the responsibility of a fund manager with a specific skill set. Secondly, it is cost effective to spread the costs associated with managing the fund across multiple investors. And finally, larger funds can be more effectively diversified.
Certain types of funds are also beneficial to the economy of a country. They can be structured to encourage and incentivize savings. This in turn provides capital to fund economic growth and job creation. Investment funds are defined along several criteria. These include a fund’s legal structure, the asset classes it invests in, its objectives, and the investment strategy it follows.
Important investment fund terms
Before we discuss the different types of investment funds, it may be worthwhile highlighting some of the important terms used to describe funds.
- Open end funds and close end funds – Open end funds are structured so that capital can be invested or redeemed at any time. Typically, an investor can invest or redeem capital on a daily basis, though for some funds the period can be monthly or quarterly. A closed end fund is typically listed like a share, with a fixed number of shares. Investors can only invest or redeem capital buy buying shares from another investor or selling their shares to another investor.
- Unitized funds – Unitization of an investment fund simplifies the process of accounting for the value and performance of each individual investor’s share of a fund. It simplifies an investor’s holdings down to units, a buy price and a sell price. Unitizations is common for investments funds for retail investors.
- Active and passive management – Active management of a fund implies that buying and selling decisions are made on a regular basis when economic conditions or the outlook for underlying instruments change. A passively managed fund simply mirrors an index, with minor adjustments being made at specific intervals.
- Index funds – Index funds are passively managed funds that track an index. The legal and fee structure of each index fund can vary, however.
- Net Asset Value – The Net Asset Value, or NAV, of a fund is the value of all assets held by the fund at a given time. This is usually reported on a per unit or per share basis. The NAV of a fund is the price at which units of an open-ended fund are bought and sold. The unit price of a closed end fund is determined by supply and demand, however the price usually trades close to the NAV.
How do investment funds work?
Investment funds are typically operated by a group of companies, each with specific functions. A management company will be responsible for administration and marketing, while a fund management company will be responsible for the actual investment decisions. A third company is often responsible for safe custody of assets. Dividing the responsibilities like this reduces the opportunity to fraud and allows for the investment management company to be changed if necessary.
Each fund has a legal structure which determines the rules that govern the fund, as well as tax and legal liabilities. Certain legal structures are specifically designed with retail investors in mind. These funds offer greater levels of transparency and protection for investors. Legal structures are in turn governed by the jurisdiction in which they are forced. A fund’s mandate sets out its goals and any limitations on what securities the fund can own. The mandate will typically also outline a set of rules in place to manage risk.
The process of investing or withdrawing capital varies from one type of fund to the next. In most cases an account must first be opened. After this, investors can transfer capital to a bank account linked to the fund. The fund manager buys and sells securities to ensure the cash balance remains below a certain percentage. The remainder of the portfolio is constantly adjusted to keep it in line with the intended investment strategy.
When an investment is redeemed, capital is paid from the fund’s cash balance to the investor. If there is insufficient cash to cover the withdrawal, the fund manager will sell securities to raise cash.
What are the different types of investment funds?
The following are the types of funds most investors are likely to come across.
- Mutual funds
- Exchange traded funds (ETFs)
- Hedge funds
- Investment trusts
- Real estate investment trusts (REITs)
- Private equity and venture capital funds
- Pension funds and retirement plans
Mutual funds have traditionally been the most popular form of investment fund for individual investors – though ETFs have become more popular in recent years. Mutual funds are sometimes known as unit trusts or collective investment schemes. They are open ended and unitized, which allows investors to buy or sell units at the NAV each day.
Some mutual funds are index funds that are managed passively. However, the majority of mutual funds are actively managed. Many of these funds have underperformed their benchmarks over the past two decades. This has led to one of the today’s most common investing myths – the idea that active investing is dead. Market conditions have not favored active investment strategies over the past decade. However, it is likely that active investing, and by association mutual funds, will regain some popularity in the future.
Exchange traded funds (ETFs)
ETFs are publicly listed investment vehicles and are managed using passive investing strategies. ETFs track well known indexes like the S&P 500 and FTSE 100, as well as custom index designed to achieve specific objectives.
Exchange traded funds are close end funds and units are bought and sold like any other listed shares. Units are not exchanged at the NAV of each unit, but at a price determined by supply and demand. New fund shares can be created when demand increases or cancelled when there is too much supply.
ETF investing is relatively new, with the first fund only being launched in 1993. However, ETFs have gained popularity due to the lower fees and the fact that most mutual funds have failed to meet their benchmark.
Hedge funds are investment funds with more flexible mandates than ETFs or mutual funds. Hedge funds are often able to use leverage, derivatives and short selling strategies to generate profits in any type of market environment. Unlike most equity funds, hedge funds can generate positive returns during bear markets as well as from short term price movements. There are several types of hedge funds, all employing different strategies and asset classes, and with different objectives. For the most part, hedge funds are designed to reduce volatility and portfolio risk.
Hedge funds have historically only been available to large funds and very wealthy investors, but they are increasingly being made accessible for retail investors. Catana Capital’s Data Intelligence Fund is an example of a fund that is available to all investors. The fund uses an innovative investment strategy to generate real returns with low correlation to equity indices. The fund strategy employs artificial intelligence to analyze user generated data and new sources in real time. This data is used to assess market sentiment and generate trading ideas.
Investment trusts are similar to ETFs in that they are publicly listed trusts – but they do not track indexes. In most cases investment trusts focus on a specific strategy or sector. These funds were more popular before mutual funds and ETFs came about. They still exist in certain industries where the structure is beneficial.
REITs, or real estate investment trusts, are investment trusts that invest in real estate. In most countries, REITs are a specific type of entity with their own limitations and tax obligations. REITs pay dividends and are regarded as an alternative to bonds or preference shares.
Private equity and venture capital funds
Private equity funds invest in established companies that are not publicly traded. Venture capital funds invest in newer, private companies that may not yet be profitable. Most of these funds are only available to high net worth investors and institutions. Increasingly, private market funds are being made available to retail investors through fund of fund structures.
Pension funds and retirement plans
Pension and retirement funds come in various forms around the world. They have one or two notable characteristics. Firstly, many are sponsored or administered by companies for employees. Typically, the employer and the employee make monthly contributions.
The other notable characteristic is that taxes are often deferred within a retirement plan. This means income and gains are not taxed, and tax is only paid when withdrawals are made during retirement. This allows the fund’s assets to compound tax free until retirement.
Investment funds vs. direct investments
There are a number of points to consider when deciding between direct investments and a fund.
- Fees – The fees charged by a fund can make a big difference to the ultimate performance. In the past, management fees were quite high and long-term investors could benefit from managing their own portfolios. However, the fees charged by many ETFs are so low that the benefit of managing your own portfolio is now marginal. Generally, funds with expense ratios below 0.3% are hard to beat in terms of costs.
- Diversification and portfolio size – It is easier and cheaper to achieve diversification with funds than individual securities. However, this also means that a fund or a portfolio of funds is unlikely to benefit meaningfully from the performance of any individual stocks.
- Skills and time – Perhaps most important is the fact that most investors don’t have the skills or time to manage a portfolio made up entirely of individual securities. In most cases investors benefit most from a mix of investment funds and individual securities.
Characteristics of a good investment fund
Just as it is impossible to predict the future it is also impossible to know how well a fund will perform in the future. However, there are a few attributes that can tilt the odds of picking a good investment. Active funds should have a good track record over the long term and especially under a range of differing market conditions. If a fund has a shorter track record, the fund manager’s track record should be studied. The best funds have a long-term focus and capture major investment themes while avoiding short term fads. Fees should be in line with similar funds.
Passive funds should track indexes with a fairly large universe, like the S&P 500 and FTSE 100 do. For most investors, index funds should be broad based and not sector specific. An expense ratio below 0.3% is preferable, and there should also be good liquidity.
Pros and cons of investment funds
The most important advantage of investment funds is the diversification they offer easily and cheaply. Individual funds are already diversified, but funds invested in different asset classes can also be used to achieve broad asset allocation. In most countries there are tax advantages to investing in certain types of funds. If you earn capital gains on direct investment you will probably have to pay tax on those gains when you sell the shares. When underlying investments within investment funds are sold, there is no tax liability. Capital gains tax may be due when the fund is sold, but capital can compound more efficiently within the fund before it is sold.
Good fund managers are more adept than most individual investors at navigating challenging periods in the market. Experienced fund managers are often able to spot the investment warning signs that precede bear markets. Historically the downside of funds was the high fees that were charged. Management fees are a lot lower than they used to be and this is less of disadvantage nowadays. In the place of fees though, is the large number of funds available these days. This can make it challenging to find the most suitable funds to achieve investment goals.
The other disadvantage is the fact that funds are unlikely to earn the higher returns of a concentrated and actively managed portfolio. Successful funds tend to attract large amounts of capital which then acts as a drag on performance. On the other hand, the smaller funds that may outperform are far riskier and difficult to pick.
Conclusion: Investing in investment funds
Investment funds are very useful tools for building an investment portfolio, and to achieve long term goals. However, they are not the only solution and are probably best used alongside a few direct investments.