Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

Mutual Funds and Other Pooled Investments

Mutual Funds and Other Pooled Investments

Many investors choose to participate in a pooled investment vehicle rather than assemble a portfolio of securities by themselves. There are several types of pooled investment vehicles. Mutual funds and exchange-traded funds (ETFs) tend to have low minimums while hedge funds and private equity funds may require large investment amounts.

Mutual Funds

The value of a mutual fund is referred to as the Net Asset Value (NAV). It is computed based on the closing price of the underlying securities held by the fund. Each investor owns a number of shares in the fund which represents a pro-rata claim on the value of the mutual fund.

Open-end Fund

An open-end mutual fund will accept new investor inflows and issue new investors shares in the mutual fund priced at the NAV of the fund at the time of investment. Investors can also sell their mutual fund shares at the prevailing NAV. Therefore, the total number of shares at the disposal of the mutual fund will change depending on its net inflows or outflows.

The portfolio manager of an open-end fund has to manage the cash inflows and outflows. They may, in fact, have to liquidate fund assets to meet redemption requests. Otherwise, they may feel pressure stemming from the demand for more investment opportunities when there are large inflows to the fund. The structure makes it easy for the mutual fund to grow in size by attracting investor assets.

Closed-end Fund

A closed-end fund will not create new shares when a new investor wants to buy shares. Instead, an existing investor will have to sell their shares to the new investor. The total number of shares in issue is fixed. Transactions do not necessarily occur at the NAV of the fund but may be at a premium or discount to NAV.

The portfolio manager of a closed-end fund does not have to manage the cash inflows and outflows. Closed-end funds tend to attract fewer investor assets and only make up a small portion of the mutual fund universe.

Load and No-load Funds

Mutual funds can also be classified as load or no-load funds. A load fund charges investors a sales charge fee to buy, hold or sell shares in the fund. These funds are usually sold by retail brokers who may receive a portion of the fee as commission. These types of funds are increasingly becoming less popular.

A no-load fund does not charge a transaction-based fee but charges an annual fee based on a percentage of the fund’s NAV.

Types of Mutual Funds

Mutual funds are broadly classified according to the type of underlying assets they invest in.

Money Market Funds

Money market funds are often seen as substitutes for bank deposits. However, they are not insured in the same way and, therefore, there is some degree of risk over a bank deposit. Money market funds are either taxable or tax-free. Taxable money market funds invest in short-term corporate and federal government debt. Tax-free funds invest in short-term state and local government debt.

Bond Mutual Funds

Bond mutual funds invest in individual bonds and occasionally, preference shares. A key difference between bond funds and money market funds is the maturity of the underlying bonds. Money market funds may hold positions with an overnight maturity. They rarely last longer than 90 days. A bond fund holds positions with maturities of anywhere between 1 and 30-years. They also hold bonds of various credit ratings.

Stock Mutual Funds

Stock or equity mutual funds have the most assets under management globally. They can either be actively or passively managed. A passive fund is designed to track a particular index through a buy-and-hold strategy. An actively managed fund, on the other hand, is comprised of equity securities selected by the portfolio manager seeking outperformance. The fees on actively managed funds are higher than those on passive funds and tend to be traded more actively. This more active trading has a tax implication. It attracts higher taxes relative to an index fund.

Hybrid or Balanced Funds

Hybrid or balanced funds invest in both equities and bonds. These funds are gaining popularity as lifecycle funds which target a particular retirement date become more sought after. A lifecycle fund tilts the mix of equities and bonds as the time for retirement draws near.

Other Pooled Investments

In addition to mutual funds, other pooled investments like Exchange-Traded Funds (ETFs), separately managed accounts (SMAs), hedge funds, buyout funds, and venture capital funds are available to investors.

Exchange-Traded Funds

ETFs track a basket of securities decided upon by the sponsor. The sponsor interacts with institutional investors who deposit the securities basket with the sponsor and receive creation units in the ETF in return. These units can then be sold to the public by the institutional investor. The institutional investor can also return their units to the plan sponsor in exchange for the securities basket. This creation and redemption mechanism helps to ensure the units in the ETF are priced close to the NAV.

When an investor buys an index fund, the investor buys the shares directly from the fund. However, when an investor buys an ETF, the investor buys the units (shares) from other investors the same way one buys trading equity securities. ETFs are priced throughout the trading day and the purchase of an ETF share in the open market may not be conducted at the NAV but at a price which represents investor demand at the time. Under normal market conditions, this is usually close to the NAV.

Expenses for ETFs tend to be lower than index funds, but brokerage is incurred when transacting. Dividends that arise in an ETF are paid out directly to the shareholders. Index funds and mutual funds tend to reinvest dividends.

The minimum investment amount for ETFs tends to be smaller than that for mutual funds and investors may choose to buy a single share of the ETF.

Separately Managed Accounts

SMAs, also referred to as managed accounts, wrap accounts or individually managed accounts, are portfolios managed exclusively for the investor according to their investment, tax preferences and requirements. The investor owns the underlying assets directly, unlike a mutual fund. Due to the individually tailored nature of SMAs, the minimum investment amount is significantly higher than that of a mutual fund and they are typically used by institutional investors.

Hedge Funds

Hedge fund strategies tend to be more complex than those of mutual funds. They can make use of leverage and extensive derivative positions. Many hedge funds are more loosely regulated than mutual funds but, in order to be exempted from regulations, they may not market themselves to the general public.

The minimum investment amounts are high – usually millions of dollars – and hedge funds may also impose liquidity restrictions. This means that investors have to commit to retain and maintain their investments for a particular period of time.

Buyout and Venture Capital Funds

Both buyout and venture capital funds invest in equity positions. Buyout funds aim to buy all the shares of a public company thereby occasioning privatisation of the company. Often, large amounts of debt are issued in order to buy all the shares. This is known as a leveraged buyout (LBO). The intention is to use the company’s cash flow to pay down the debt and restructure the company. This makes the restructured operation suitable for an initial public offering (IPO) or sale to another company thus providing an exit to investors.

Venture capital (VC) funds do not buy established companies but finance companies in a start-up phase. In addition to financing, VC funds offer close oversight and management input. As with buyout funds, the intention is to list or sell the funded company in a finite and relatively short amount of time to create an exit for investors.

Question

Which option correctly represents the characteristics of ETFs and index funds?

A. Index funds are priced throughout the trading day like equity securities.

B. When investors purchase an ETF, they typically pay a brokerage fee.

C. ETFs are always priced at the net asset value (NAV) at which investors transact at the closing price the a day.

Solution

The correct answer is B.

ETFs trade like equity securities throughout the trading day. When buying ETF shares, investors typically pay a brokerage amount.

Option C is incorrect. ETFs are usually priced close to NAV but may be priced at a premium or discount given market forces (supply and demand).

Option A is incorrect. Index funds are priced at NAV, do not attract brokerage fees, and are transacted at the closing price on the day.

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons



    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.