Investment funds create baskets of assets and package them for investors. Most funds stick to publicly traded stocks or bonds, but some funds will include commodities, real estate, cryptocurrency, or other more exotic assets.
Most likely, you will start your investing journey with one of these funds either because you want to start simple or because it is the only option made available to you through your 401k, 403b, or similar retirement account at work.
Before we even begin to think about what type of fund to pick (which I will probably cover next time), we need to cover the big concepts in funds such as fund types, investments owned, valuation, and management. Otherwise, the comparisons and evaluations regarding what to buy won’t make sense.
Fund Types: Exchange Traded, Closed-End, and Mutual Funds
According to the Investment Company Institute (ICI), 120 million Americans invest in some type of fund. Anyone offered a 401k or a 403b package remembers the thick and very confusing booklet (or many-page PDF file) containing the many different investment options in their program.
Usually, these are mutual funds, but more sophisticated plans will offer a brokerage option that allows for the purchase of stocks. The brokerage option enables the purchase of index and closed end funds, but what the heck are all these things and why do they exist?
Funds Exist to Reduce Risk
All fund types attempt to reduce investor risk and increase investor return through a collection of assets owned by the fund. Buying a single investment means you can be wrong about if the investment is a good investment. Investors have sought risk reduction and access to expertise since the first closed end funds established in the 1860s.
Purchasing a diversified selection of investments, even within a narrow scope such as AI stocks or residential apartment buildings, spreads out the risk. Funds spread out the risk with the guidance of professional managers.
Fund Types Defined
Financial regulations define legal differences between the fund types that will be beyond the scope of beginning and intermediate investors. Instead, we will focus on more fundamental distinctions and similarities useful to normal retail investors like us.
- Mutual Funds are open-ended investment vehicles that pool money from many different investors to purchase other investments
- Exchange Traded Funds (ETFs) are open-ended investment vehicles similar to mutual funds, but they trade on the stock market
- Closed End Funds are close-ended investment vehicles that are similar to mutual funds, but they don’t issue more shares and they trade on the stock market.
Brief definitions like these remain unclear unless we also explain terms used above:
- Investment vehicles are legal proxies created to allow consumers to invest indirectly. Instead of going to 500 different companies and buying fractional shares, you can instead put money directly into an S&P 500 index fund.
- Open-ended funds can grow as more people put money into the fund and shrink as more people take money out of the fund.
- Closed-ended funds are a fixed size with a fixed number of shares for the lifetime of the fund.
While this edges us closer to understanding, the true picture becomes more clear only when we compare and contrast specific features and benefits.
How to Buy
You purchase ETFs and CEFs through any brokerage account. You will pay the price set by the market price on that day and you buy and sell by the share (some accounts permit fractional shares).
To buy mutual funds can take more effort. Some brokerage accounts and many 401k accounts offer mutual funds, but only a cultivated selection of mutual funds.
Some mutual funds may only be available through specific brokerages and other mutual funds may only be purchased directly through the issuing company. While it can be easy to buy A mutual fund, it may take more work to buy a SPECIFIC mutual fund if it isn’t in your 401k list.
Mutual funds price themselves once per day (US funds typically at 4pm Eastern Time). You send them a fixed amount of money (say $5,000) and then after the price is set for the day, the fund will convert that money into shares of the mutual fund.
As publicly traded investments, ETFs and CEFs are eligible for advanced trading methods:
- Short selling: selling stock you don’t have in hopes of buying it back later, cheaper.
- Margin: buying the stock using borrowed money to allow you to buy more stock
- Options: buying or selling contracts to buy or sell the stock in the future at a set price
Mutual funds will not be eligible for these advanced trading methods.
What Are You Buying?
We already noted that funds let you buy a collection of investments. But which investments?
The contents of the fund will often be described in the title of the fund and detailed in the prospectus, or sales materials, for the fund. The prospectus will also provide at least some details about the top investment categories and specific investments within the fund.
Closed end funds will be the least transparent and exchange traded funds will be the most transparent about the fund contents. Closed end funds also have the option to use debt, options and other advanced investment options without detailed disclosure.
Fund Investment Categories
To understand the title and descriptions of funds, we need to understand the investment category terms.
- Growth Funds focus on investments expected to grow in value- most commonly, hot stocks expected to grow significantly over the short term (under 5 years)
- Value Funds target stocks that may have recently been beaten up or that underperformed and therefore show potential for a price rebound, even if the company is not expected to grow as much as a hot growth stock.
- Income Funds seek to provide returns through income generating investments such as bonds, real estate, and dividend paying stocks
- Category Funds focus on specific types of investments such as technology, energy, utilities, cryptocurrencies, or short term treasury bonds.
- Target Retirement Funds follow a doctrine that attempts to match growth and volatility to the expected retirement date through a mix of stocks and bonds
- Index Funds match the contents of the fund to a published index such as the Standard & Poors 500
- Options Funds place option bets on assets, usually to provide high dividend income (although also usually with higher risk)
Within any of these funds, we will see a number of recurring terms that define the types of investments within the fund or related to the fund:
- Fixed income investments pay a fixed (as opposed to variable) interest income and include CDs, treasuries, corporate, and other bonds.
- Credit quality evaluates debt based upon expected ability to pay; ratings agencies use letter grades with AAA as a top rating for quality and C or D ratings for the poorest rated bonds
- Interest rate sensitivity evaluates a fixed income investment’s vulnerability to changes in interest rates with high sensitivity indicating higher risk for investors with changes in US Federal or other benchmark interest rates (such as the London InterBank Offered Rate or LIBOR).
- Large cap, or large capitalization, funds buy companies with the top 5% highest stock valuation (share price times the number of shares); these stable businesses are also called blue chip stocks
- Mid cap, or middle capitalization funds focus on companies with the next 15% of the largest companies below the top 5%.
- Small cap, or small capitalization funds focus on the bottom 80% of stocks by capitalization; investors regard small cap stocks as more likely to fail (riskier) although they also have more room to grow.
Historically, most companies began as small caps stocks and became successful to become mid or large cap stocks. Recent long-term private equity fund companies such as Uber or SpaceX now become large caps during their public offerings.
Quick Overview on Target Retirement Funds
Target retirement funds need a bit more explanation, but we should cover them since they can be found in nearly all retirement accounts. To explain the concept we also need a brief understanding of the risk of investment categories.
Stocks provide great growth potential, but their risk also means that in any given year, the investment might also suffer losses. If you are getting ready to retire, you don’t want to see a sudden drop of 20-50% in your retirement portfolio!
Bonds and other fixed income investments tend to be more stable and we can predict their value more reliably. However, they don’t grow much, so they make it hard to grow a large retirement account balance.
People ready to retire are expected to need predictability and people with a long way to go are expected to be able to tolerate more risk because they have more time to make up losses. Thus the rule of thumb is to use your age as a rough determiner of the percentage of stable bonds in your portfolio.
Youngsters in their 30s should have a small 30% of bonds and focus on growth stocks. Retirees close to 65 should have 65% in bonds and only have 35% in stocks.
Or so goes the theory. Your personal risk profile may be different. Personally, I have never followed this percentage (we’re still at ~70% stocks), but these target funds do so strictly.
Fund Managers and Manager Fees
All funds will be managed and run by professional investment managers or teams of managers. However, the amount of work and skill required by those managers will depend upon the type of fund and the targeted investments of the fund.
Actively managed funds buy and sell assets frequently to generate additional returns for shareholders. However, actively managed funds also rack up additional trading expenses and taxes as well.
Passively managed funds make purchases and then generally hold the investments with dramatically less trading. These funds tend to have lower fees and, in general, will generate better returns than actively traded funds over the long term. More on this next time.
Mutual funds and closed end funds generally tend to be actively managed funds. Index-based ETFs will generally be passively managed funds, but other ETFs may be actively managed so you need to check the prospectus for more information.
All funds disclose the management teams and expense ratios (fees as a percentage of the assets). Trading fees and taxes can be seen in historical data, but funds don’t disclose this data directly.
These fees and expenses eat at the returns of the fund. The higher the fees, the better paid the fund managers, but not necessarily the better the fund return.
What is it Worth?
As we covered last week in Basic Investment Valuation, the market price of any investment may differ from the underlying value of the investment. Funds are no different; some trade close to the underlying asset value and others might not.
Exchange traded funds tend to trade closest to the underlying value, especially index funds. Mutual funds only price once per day and don’t offer enough transparency of their holdings to help retail investors determine the gap, if any, between the asset values and the price.
As open-ended funds, ETFs and mutual funds, buy or sell shares of the underlying investments and issue or take back additional shares from the market. These actions prevent the market supply and demand forces from creating a large gap between share price and value.
Closed end funds will be subject to supply and demand pressures. They never issue new shares, so a buyer imbalance makes the price soar and a seller imbalance drops the price.
This often leads CEFs to maintain the largest gaps between asset values and trading prices. Sadly they also offer the least transparency for a retail investor to examine that gap to determine if they are looking at a bargain or an overpriced opportunity.
Next Steps
This column lays out the basics for fund definitions and is the basic homework necessary to understand the vocabulary of investing in funds. My next column will cover how to actually pick a fund.
If you have a retirement plan, take a look at your options and see if this column helps you understand a bit better. If you still have questions, let me know! It would help me to frame future columns to answer specific questions and I want to make these guides as useful as possible to each of you.
Most informative for the novice investor. Much appreciated!