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Mutual funds and other pooled investments

Major investment products offered by asset managers include mutual funds, separately managed accounts, exchange-traded funds, hedge funds, and private equity/venture capital funds.

A mutual fund is an investment vehicle in which investors pool their monies which are then used to invest in securities and each participant in the pool receives shares representing his claim on the pooled investments. The value of a mutual fund is called net asset value (NAV), and it is computed daily. Mutual funds are the primary investment products used by individual investors, but many institutions also invest in mutual funds.

Open-end fund vs closed-end fund

An open-end fund is one that allows new investors to participate in the fund by issuing them new shares at the fund’s net asset value (NAV) per share. It also allows existing investors to redeem their shares at the prevailing NAV per share. But a closed-end fund does not allow any such issue or redemption of shares, instead, investors must sell shares to each other. This may cause the market price of a share of a mutual fund to trade either a premium or discount to its NAV. An open-end fund can grow quickly due to the flexibility it offers to investors, but this flexibility is at the cost of freedom enjoyed by the portfolio manager who must accommodate continuous cash inflows and outflows and maintain a cash reserve. A closed-end fund provides greater freedom to the manager but none to the investor and hence, it is less popular.

Load-fund vs no-load fund

A no-load fund is one that does not charge any fee for investment or redemption but charges only an annual fee based on assets-under-management. A load-fund is one that charges a fee per each share issue or redemption in addition to the annual management fee.

Fund types based on target investments

Mutual funds can also be differentiated based on their target investments.

Money market funds

Money market funds are funds that invest in very short-term fixed-income securities such as certificates of deposit, commercial paper, etc. They maintain high liquidity and have low risk. Some invest in tax-free assets such as municipal bonds.

Bond mutual funds

A bond mutual fund invests in fixed-income securities of longer duration. They may be further categorized into global, government, corporate, high-yield, inflation-protected, and tax-free, depending on their target bonds.

Stock mutual funds

Stock mutual funds are funds that invest in equity securities. They are further classified into actively managed funds and index funds.

Actively-managed stock funds attempt to beat the benchmark, charge a higher fee, have greater investment turnover and may result in higher taxes (because they realize more capital gains).

Index funds, on the other hand, replicate a stock-market index, charge lower fees, have low turnover, and taxes.

Hybrid/balanced funds are funds which invest simultaneously in both equity and debt. Many of these are lifecycle funds whose allocation changes with changes in typical age and risk and return profile of its investors.

Separately managed accounts

Separately-managed accounts are portfolios managed by asset managers on behalf of institutions and large individual investors. They differ from mutual funds in that all the assets belong to a single institutional or individual investor. There is a certain minimum investment requirement and SMAs are managed according to investment needs and considerations of the client.

Exchange-traded funds

Exchange-traded funds are investment funds whose shares trade on an exchange. They are structured like an open-end fund, but they differ significant from mutual funds in that (a) they trade continuously at market-determined price unlike a mutual fund which is traded only once, (b) they can be sold short or bought on margin but not mutual fund shares, (c) they distribute dividends and gains to investors while a mutual fund usually reinvests them.

Hedge funds

Hedge funds are private investment vehicles that use leverage, derivatives, and long-short positions in a diverse range of investment strategies in order to return independent of broad market movements. Distinguishing characteristics of hedge funds include: (a) short-selling, (b) focus on absolute return, (c) use of leverage, (d) low correlation with traditional investments, and (e) a fee structure which is a combination of the assets-under-management fee plus a performance fee.

Hedge funds are private investments in the sense that they disclose less information, and are not readily available for all investors due to high initial investment requirement, a minimum investment period (during which investments cannot be liquidated), regulatory requirements, etc.

Private equity and venture capital funds

Private equity and venture capital funds are investment vehicles that invest in companies with a more hands-on approach. These funds are actively involved in the management and strategy formulation of the target company. They aim to improve a company’s performance and position and then sell it at a higher price to another firm or through an IPO. These funds are structured like hedge funds: limited liability with a general partner who manages the fund and a number of limited partners.

These funds earn different types of fees: (a) management fees based on assets under management (AUM), (b) transaction fees, paid by the portfolio companies for different services of the funds, (c) carried interest, performance-based fee based on a percentage of return in excess of some benchmark, and (d) investment income earned on funds contributed to the fund.

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