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 vehicle, 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) and is computed based on the closing price of 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 will 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 in issue of the mutual fund will change dependent on the net inflows/outflows to the fund.

The portfolio manager of an open-end fund has to manage the cash inflows and outflows and may have to liquidate fund assets to meet redemption requests or conversely, feel pressured to keep finding more investment opportunities when there are large inflows to the fund. The structure does make 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 but 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 will charge 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 less popular.

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

Types of Mutual Funds

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

Money Market Funds

Money market funds are often seen as a substitute for bank deposits but they are not insured in the same way, 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 and rarely longer than 90 days. A bond fund holds positions with maturities of anywhere between 1 and 30-years as well as bonds of various credit ratings.

Stock Mutual Funds

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

Hybrid/Balanced Funds

Hybrid/balanced fund invest in both equities and bonds. These funds are gaining in 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 to retirement decreases.

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 in return receive creation units in the ETF. 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 in an equivalent manner to trading equity securities. ETFs are priced throughout the trading day and the purchase of an ETF share on the open market may not be conducted at the NAV but at a price which represents investor demand at the time. In 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 while index funds and mutual funds tend to reinvest dividends.

The minimum investment amounts for ETFs tends to be smaller than 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 investing and 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 and 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 exempt from regulations may not market themselves to the general public. The minimum investment amounts are high and hedge funds may also impose liquidity restrictions. This means investors have to commit to remaining invested for a particular time frame.

The minimum investment amounts are high and hedge funds may also impose liquidity restrictions. This means investors have to commit to remaining invested for a particular time frame. Hedge funds charge a management fee and also a performance fee on outperformance over a stated benchmark.

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 thus taking the company private. Often, large amounts of debt are issued in order to buy all the shares and 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 provide financing for companies in a start-up phase. In addition to providing financing, VC funds will also 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 NAV at investors transact at the closing price on the day.

Solution

The correct answer is B.

ETFs trade like equity securities throughout the trading day. They are usually priced close to NAV but may be priced at a premium or discount. When buying ETF shares, investors typically pay a brokerage amount. Index funds are priced at NAV, do not attract brokerage fees and are transacted at the closing price on the day.

 

Reading 39 LOS 39e:

Describe mutual funds and compare them with other pooled investment products

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