What is an Investment Fund?
An investment fund pools capital from many investors. Each investor has partial ownership and the fund invests according to the fund’s objectives. Investment funds offer a wide range of investment opportunities. They can also benefit from diversification, lower transaction costs and management expertise. This helps mitigate some of the risk that individual investors take on.
Types of Investment Funds:
- Open-end vs. Closed-end funds
- Mutual funds
- Hedge funds
- Index funds
These fund types serve similar purposes, fundamentally. They allow you to invest in a diversified portfolio of assets that you might not otherwise be able to gather yourself. But it’s important to understand the features that make each fund type unique.
Open-End vs. Closed-End Funds
Open-end funds, like those offered by Fidelity, Vanguard and other leading mutual fund groups, continuously offer and redeem shares based on each day’s closing net asset value (NAV). Shares are priced each day based on their NAV.
Closed-end funds are different. They raise money through an IPO (initial public offering), just like a company going public, and then begin trading on an exchange.
Because these funds trade like stocks, you buy them through a brokerage account. And you can trade them intraday using market or limit orders. They are marginable like stocks too.
A closed-end fund’s market price at any given time may be higher or lower than its NAV. If it’s trading above the NAV, it’s said to be trading at a premium. If it’s trading below the NAV, it’s trading at a discount.
Mutual funds are the oldest type of investment fund. Like the other types, they’re vehicles that pool money from investors to buy securities. The basket of assets is priced and sold to the public on a daily basis.
The daily basis part is an important distinction. Unlike other fund types, which we’ll discuss in a moment, the price of a mutual fund changes exactly once a day. In an actively managed mutual fund, the managers may trade the assets inside the fund throughout the trading day. But you can’t make money trading shares of the fund intraday.
That’s part of the reason mutual funds are more popular for retirement planning. They’re not good for day traders, but they’re great for savers who want to grow their money over a long period of time.
Mutual funds come in a few flavors. Closed-end mutual funds are the simplest type. They have a fixed number of shares that can be bought or sold only when they’re available on the market.
There are also open-end funds, which can create and retire new shares based on investor demand. And then there are unit investment trusts (UITs), which are static portfolios of securities with no management.
Mutual funds have many advantages. They allow investors to buy into a diversified portfolio of high-value assets without having to manage that portfolio. However, that convenience comes at a price. Mutual funds (especially actively managed ones) often charge fees that may eat away at returns.
Another disadvantage of mutual funds is their tax inefficiency. Money in a mutual fund is usually tax-exempt as long as it stays invested. But when a mutual fund sells some of its portfolio at a profit, it is required by law to distribute those profits to shareholders. Those payments are taxable.
ETFs (Exchange-Traded Funds)
An ETF is a listed security that tracks an index consisting of a portfolio of individual securities. As with mutual funds, when you buy an ETF, you don’t pick a specific security. Instead, you choose a particular asset class, sector, theme, country or investment strategy.
Two notable types of ETFs are leveraged ETFs (which track some multiple of the price of their underlying assets) and inverse ETFs (which track the opposite of their underlying assets). These funds give traders the ability to amplify, or hedge, their bets without using complex instruments like derivatives.
The ability to trade ETFs intraday can be an advantage in some situations. If the market crashes, for example, you can sell before the end of the trading day. With a mutual fund, you’re stuck waiting until 4 p.m. to sell, at which point the fund may have shed significant value.
But the ability to trade actively can also be a handicap. Those who trade frequently risk trading on impulse or anxiety. And that’s a recipe for buying high and selling low. Mutual funds don’t give you the option of making reckless intraday trading decisions.
With ETFs, you can invest in everything from stocks, bonds and the U.S. technology sector to Dividend Aristocrats, foreign currency and even timber. ETFs also offer distinct advantages over traditional mutual funds. You can buy and sell ETFs as easily as you buy a share of Apple (Nasdaq: AAPL).
Finally, ETFs tend to be a bit cheaper than mutual funds. They don’t have to distribute realized capital gains to shareholders, so they tend to come with a smaller tax bill. Also, many ETFs are passively managed, which usually means a lower expense ratio.
ETFs don’t have big investment minimums. They’re generally more tax-efficient. And you can invest in ETFs that offer leverage or even profit when markets go down. No wonder ETFs have come to dominate stock exchanges over the past decade.
Hedge funds pool huge amounts of money from wealthy investors, Wall Street banks and, yes, other hedge funds. Their goal is to make money regardless of the overall market movements. Some of them invest in bonds, some in commodities, some in foreign markets, some in futures and options. And some short stocks, betting their prices will fall, not rise.
Others turn almost any kind of cash flow – including credit card payments, home mortgages, corporate loans, plane leases and even movie theater revenue – into securities and trade them. Hedge funds hold unparalleled sway over the world’s financial markets today. They are responsible for a good chunk of all stock trading in the market.
Much of what they are doing is good. For example, hedge funds help spread investment risk among many partners. In some ways, this “risk dispersion” has acted like a safety valve for investment banks and other lenders. However, with so much leveraged money sloshing around in these funds, the potential for catastrophe is increasing. Also, hedge funds are struggling to beat the market but are still charging higher fees.
Index funds aren’t their own type of fund. For example, there are both ETF and mutual fund index funds. Still, they’re worth discussing because they have a unique asset profile.
As the name implies, index funds are baskets that try to contain all the securities in a particular index. You could spend a fortune buying a weighted amount of stock in the 500 largest public companies in America… or you could just buy a few shares of an S&P 500 index fund.
Index funds represent some of the most diversified investment vehicles on the market. In the case of an S&P 500 fund, containing 500 holdings, you can’t get much more diversified than that. Instead of picking and choosing different securities, you get a piece of everything. This strategy can generate steady returns with lower risk.
Index funds can be valuable to long-term investors because of their simple strategy. Betting on the market’s long-term trends can be a great move.
Few active managers and traders outperform the benchmark indexes over a period of decades. However, an actively managed fund may earn bigger short-term gains than an index fund would.
Types of Investment Funds Summarized
As you can see, mutual funds, ETFs, hedge funds and index funds are all similar concepts, but there are a number of nuanced differences between them. These are important for any investor to understand.