Funds

Funds, in terms of investing, are supplies of capital that belong to multiple investors. This capital collectively purchases securities. Each investor in a fund retains ownership and control of his or her own shares. Funds grant investors a broader selection of investment opportunities than they would normally enjoy on their own, as well as the benefit of professional management of the investment. The fees associated with trading the securities procured by an investment fund also tend to be much lower than individual investors would generally be able to obtain investing on their own.

Funds, in terms of investing, are supplies of capital that belong to multiple investors. This capital collectively purchases securities. Each investor in a fund retains ownership and control of his or her own shares. Funds grant investors a broader selection of investment opportunities than they would normally enjoy on their own, as well as the benefit of professional management of the investment. The fees associated with trading the securities procured by an investment fund also tend to be much lower than individual investors would generally be able to obtain investing on their own. Some of the most common types of investment funds include exchanged traded funds, mutual funds, and closed-end funds.

In an investment fund setting, the individual investors do not control the investment of the fund’s assets. Rather, a fund manager uses the pool of capital provided by the investors to purchase a select asset or group of assets according to a particular set of rules established by the fund and agreed upon by the investors. Those rules are the fund’s “mandate,” and there are hundreds of different mandates for the thousands of funds in existence. Each mandate has its own goal, whether it is increasing the value of the assets in the fund, keeping the value of the assets steady, or protecting the assets from loss.

Mutual Funds

Mutual funds are open-end funds that raise money by selling shares like CEFs, but they can sell more shares in the future and use that money to buy more assets. Unlike investors in a corporation, new investors in a mutual fund do not dilute the ownership of existing shareholders because mutual funds always trade at the net asset value of the fund. In other words, when you pay $10 to a mutual fund, you are buying $10 worth of mutual fund holdings. Mutual funds remain quite popular with investors, and are the largest asset class in fund investing. Mutual funds come in both active and passive forms, and employ a wide array of investing strategies. Unfortunately, mutual fund shares are only available for purchase or sale at the end of the trading day.  Moreover, many actively managed mutual funds have underperformed the indexes they track in recent years.

Exchange-Traded Funds

Exhange-Traded Funds (ETFs) are open-end funds that can receive new capital similarly to mutual funds. However, unlike mutual funds, ETFs can also trade at a discount or premium and can see share splits and reverse-splits. Investors can also buy and sell ETFs during the trading day, making them popular for their extra liquidity. The largest and most popular ETFs are those that passively track an index fund and offer very low fees. These have swelled in popularity over the last decade. In fact, the underperformance of many mutual funds is partly responsible for the popularity of exchange-traded funds some say they may soon overtake mutual funds as the most popular form of fund investment.

Closed-End Funds

Closed-End Funds are funds in which a set amount of shares sell for a set price; an amount that will never change. After the fund has sold those shares and received its proceeds, it then uses that money to buy and sell assets according to the CEFs mandate. For instance, a municipal bond CEF will sell a certain amount of shares, buy municipal bonds with the proceeds, and then never raise more money from investors again. CEFs can sell their holdings and buy other holdings, or they can use a somewhat risky strategy called “leverage” to buy more in the future. The relatively high fees of closed-end funds, as well as the potential risks, limit their appeal to a small group of investors.

Pension Funds

Pension funds invest its assets to match the liabilities of the fund that are retired workers’ benefits.  To achieve this liability matching, they strive for a steady rate of return from their investments. If the pension fund cannot get that rate of return, its assets will diminish and it will be unable to meet its obligations to its beneficiaries.

The benefit of pension funds for pensioners is simplicity.  The fund is there to make payments to the pensioner as required and the pensioner does not have to think about the fund’s investment selection or performance (that is the pension managers’ job).   Of course, the downside of this arrangement is the potential for mismanagement of the fund or poor investments that leave the fund unable to meet its obligations.

Pensions are the largest form of institutional investor in the market. They manage tremendous amounts of money, carry enormous influence in the financial world because of the enormous size of their investments, and are the biggest clients of investment banks like Goldman Sachs.

Hedge Funds

Another influential institutional investor class is the hedge fund.  Hedge funds are famous, notorious, and shrouded in mystery (and glamour) for many, but the reality is much more mundane.

Hedge funds come in several flavors.  Some invest in only stocks, some in stocks and bonds, and many in derivatives and alternative investments.  For example, a market-neutral stock hedge fund buys stocks they think are undervalued and sells stocks they think are overvalued.  The return comes from making the correct bets on the future direction of those stocks.  Since the hedge funds sell as well as buy stocks, they can theoretically make money (or at least, not lose money) when the market moves in any direction.

Fund of Funds

Finally, there is one group of meta-funds: the fund of funds. Fund of Funds invest in several different funds at the same time.  A hedge fund of funds, for instance, will invest money in many different hedge funds simultaneously.  Fund of funds have good diversification benefits.  The downside is that they have double layer fee structures that can quickly eat into any potential profits.

Management Strategy: Active and Passive Funds

The mandate and organizational structure characterizes funds.  They are also identifiable by their strategy. Each fund has a management team that charges the investors in the fund a set fee for managing their money. The structures of these fees can vary, but they are usually a percentage of the total assets under management (AUM). Typically, fund fees range from 0.1% to about 2%, with most funds somewhere between 0.5% and 1.5%.

Funds that require more effort from management usually charge more fees. Thus, funds with complex investing strategies and extremely good track-records often charge the biggest fees. These are “active funds” because the management actively chooses how to allocate the fund’s assets.

On the other hand, some funds exist to mimic or track a particular index or type of asset. These index-tracking funds are “passive funds,” and are extremely popular with retail investors due to their relatively low cost.

While active funds charge higher fees due to the amount of effort involved, passive funds have very low overhead (usually computers will automatically buy and sell assets for these funds based on algorithms). Thus, managers spend very little time and energy allocating assets because they only have to mimic an index or style. For example, stock index funds that track the Standard and Poor’s (S&P) 500 index only need to know what stocks make up the S&P 500, buy those stocks, and rebalance to ensure the fund has the right amount of each stock relative to their increase or decrease in value.

Funds Can Be an Excellent Investment Tool

In short, investment funds are capital, collected from a group of investors, for the purpose of generating a return by diversifying over many assets or by using a particular investment style.  While there are many types of funds, they mainly benefit investors by distributing risk (and revenues) among the fund’s contributors. Choosing the right type of fund is a matter of assessing one’s own investment goals, risk aversion, and the objectives and management structure of the particular fund in question.