Most individuals lack the time and expertise for picking the right securities at the right time, so many investors turn to investment funds, sometimes referred to as professionally managed assets (PMAs), that are managed by a professional manager, such as a Registered Investment Advisor (RIA), who specializes in the investments that they oversee. In regards to investments, an asset is considered property of value owned by the investor for which income can be earned or appreciation can be realized. Investment funds use high-speed computers that constantly screen securities and monitor the market for the best opportunities, since they can get all the necessary information from databases and instantly calculate financial ratios and other criteria for selecting securities.
There are many different types of funds to select, but the investor generally chooses depending on his investment time horizon, marginal income tax bracket, expected tax bracket in the future, and his tolerance for risk. Funds also make it easier to invest according to subjective criteria, such as investing in socially responsible companies. Small investors can also participate in preferred investments, which are investments that are usually only available to the wealthy.
Advantages of Investment Funds
Professionally managed assets have several advantages. Managers typically have extensive education and experience. Managers are either investment advisors who work for a RIA or work independently, or they may be brokers who work for a broker-dealer or a wire house. Most managers have advanced degrees, typically a Master of Science or PhD in finance. Or the manager may be a Chartered Financial Analyst (CFA), who must pass 3 rigorous, 6-hour examinations over at least 3 years and have at least 3 years of investment experience as a financial analyst.
There is also a certain amount of safety in many funds, because they are subjected to many laws that were enacted to prevent the types of fraud that prevailed during the 1920s, and many funds are regulated to prevent undue risk. For instance, mutual funds are prohibited from owning too large a position in 1 asset, from selling short, or from using leverage, such as borrowing money to buy securities.
A primary advantage of investment funds is that effective diversification can be achieved with a smaller investment. Diversification is generally achieved by owning assets that exhibit little, or at best, negative, correlation to each other, meaning that when the market value of 1 asset is low, other assets are higher. Generally, diversification is greater for assets of different types, such as futures and stocks, since their market values depend on different economic factors. Some diversification can be achieved within a given asset type, such as stocks, by investing in different stocks of companies with different products or services in different sectors that have different business cycles. Additional diversification can be achieved by buying growth stocks and stocks that pay a dividend, since growth stocks will do well in a strong economy, but dividend-paying stocks will do better in a depressed economy. Another effective means of diversification is by buying assets in different countries, although there are additional risks that must be considered, such as political risk or currency fluctuations. Because diversification is best achieved by buying many different assets, most small investors can only achieve adequate diversification by investing in funds.
Another benefit of investing in funds may be lower transaction costs. For instance, there is no cost in buying or selling shares of a mutual fund, because the shares are bought or redeemed by the mutual fund company at the net asset value of the fund. On the other hand, if a small investor can only buy a few shares of stock, then transaction costs will be relatively high compared to the amount invested.
Liquidity is the ability to sell an asset quickly without selling it for less than its value. Investment funds that are available to most retail investors usually have liquidity, so investors can quickly enter or exit the investment. On the other hand, investment funds that are marketed mostly to high net worth individuals or institutional investors generally have less liquidity because they are either not traded on public exchanges or sales or redemptions are restricted. Hedge funds, for instance, generally restrict redemptions, so that the hedge fund managers are not forced to sell assets to pay for redemptions.
Government oversight provides additional safety for most investment funds that can be marketed to the public. The 2 main federal laws that apply to investment funds are the Investment Company Act and the Investment Advisers Act, both enacted in 1940, which give primary regulatory authority to the Securities and Exchange Commission (SEC). Additionally, funds are also subject to numerous state laws and the rules of other state and federal agencies.
The Investment Company Act of 1940 (ICA) requires that investment companies subject to the Act be restricted in the following ways:
- securities must be held by a custodian, not by the fund
- at least 90% of the fund's taxable ordinary income must be distributed to shareholders to avoid taxation at the entity level
- securities cannot be bought on margin nor can they be sold short
- an investment in another investment company cannot exceed 10% of its assets
- investment companies must register with the SEC and file annual reports, investment policies, and other information required by the SEC
- the capital structure of investment funds are restricted: they cannot issue bonds or preferred stock; they can only borrow money from banks.
Further restraints on investment funds are imposed by the Investment Advisers Act of 1940 (IAA) which allows the SEC to regulate investment advisors and financial planners, and others that provide investment advice to the public. However, the SEC has largely delegated this oversight to the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization of brokers and dealers. The IAA stipulates that the investment adviser subject to its Act owes a fiduciary duty to the client, meaning that they must act in the best interest of the client. Fraud or taking advantage of the client in other ways is prohibited. Conflicts of interest are to be avoided and any material facts known to the investment advisor must be disclosed to the client. Investment advisors who violate the IAA can be sanctioned or fined, and their license may be suspended or revoked.
Disadvantages of Investment Funds
There are several disadvantages to investment funds. A primary disadvantage is the numerous fees charged by the funds, which reduces investment returns, sometimes by a considerable amount. Some fees must be paid to operate the fund, such as paying for transaction costs. Most of the remaining fees are used to pay sales commissions or to compensate the managers of the fund. A maximum of 1% of the fund's assets may be charged as 12b-1 fees to cover the cost of distribution and marketing of the fund. No more than 0.25% of the 12b-1 fees can be charged to cover the servicing of clients, such as responding to emails or phone calls from clients. Generally, actively managed funds have higher fees than funds based on indexes. Much higher fees are charged by funds that are primarily for high net worth individuals or institutional investors, such as hedge funds, managed futures, and private equity.
One thing to note about fees is that the returns earned by an investment fund should exceed the general market by at least the amount of the fees; otherwise, an investor would be better off simply buying an index fund or other passively managed fund.
Another disadvantage of investment funds is that the investor has less control over the recognition of taxable income. Because most investment funds are pass-through entities, meaning that the fund itself pays no taxes, but passes through the tax liability to the shareholder, the shareholder must pay taxes on taxable income earned by the fund that is distributed to the shareholder, even if the shareholder only recently invested in the fund. Most of the income is in the form of ordinary dividends, which are subject to marginal tax rates, and qualified dividends, which are subject to a more favorable tax rate, which, for most taxpayers, is 15%. Distributions will also include capital gain distributions, which are taxed according to the fund's holding period for the pertinent securities. If the fund held the security for more than 1 year, then the shareholder will only have to pay the long-term capital gains rate instead of the marginal rate on the gain; if the fund held the security for 1 year or less, then the shareholder must pay the marginal tax rate on the gain.
Another potential disadvantage is the inability to customize a portfolio. This may be an advantage for an inexperienced investor and, even for the experienced investor; it greatly reduces the time consumed in monitoring investments and making decisions on the buying or selling of individual securities. However, the investor may have difficulty in finding a fund that closely matches his investment objective.
Types of Investment Funds
There are many types of investment funds:
- mutual funds
- closed-end funds
- unit investment trusts
- exchange traded funds
- hedge funds
- managed futures
- private equity funds
- limited partnership investments
- real estate investment trusts
- individually managed and separately managed accounts
- variable life insurance
- variable annuities.
The following is a brief overview of each type of fund, with links to more in-depth articles:
The main benefit of mutual funds is that the fund always stands ready to either sell or redeem shares of its funds from the investors at net asset value. Mutual funds can be classified as:
- money market funds that invest in money market instruments or other near cash equivalents
- equity funds that invest mostly in stocks
- fixed income funds
- hybrid funds, a mixture of stocks and bonds in the same fund
Closed-end funds are mutual funds that have a constant number of shares that are sold on public exchanges, and often sell at a discount. Most closed-end funds are usually smaller than open-end mutual funds and usually have higher expenses. Because of their discount, CEFs have higher yields than their underlying securities, which are often bonds.
Unit investment trusts are similar to closed-end funds except that the portfolio is fixed with the predefined lifetime, generally 2 years or less. Shares are called units that trade on stock exchanges. Traditionally, UITs held bonds, but many UITs today also hold stocks. UITs are organized by sponsors according to trust indentures — similar to bond indentures — which are legal contracts specifying the terms and obligations of the sponsor and the beneficiaries of the trust.
Exchange-traded funds are much like closed-end funds, in that ETF shares represent a portfolios of securities that are traded on a stock exchange. However, ETFs use arbitrage to maintain the net asset value of the fund with the underlying securities. Hence, ETFs rarely sell at a substantial premium or discount to their net asset values. ETFs are also highly tax efficient because ETFs are not forced to sell securities to redeem their shares to withdrawing investors. They also charge very low fees, since most of them are based on an index.
Hedge funds also buy and sell securities but use riskier methods, such as short selling and using derivatives, to try to attain outsized gains. More often than not, the returns from hedge funds is less than what can be obtained from much less riskier investments, especially after subtracting their hefty maintenance and performance fees, which can be as much as 22% of any profits. Hedge funds are generally sold as a private placement, since they are not subject to the Investment Company Act of 1940. Most hedge funds have a minimum net worth before accepting investors.
Master limited partnerships (MLPs) are publicly traded partnerships that are bought mainly for their high income. The main advantage of MLPs is that only part of their distributions are currently taxed; the remainder of the distributions lowers the investor's tax basis in the MLP units, which represents the ownership interest in the partnership, like shares in a mutual fund, thus deferring taxes on that portion until the MLP units are sold. MLPs are actual businesses that, for tax reasons, are restricted to certain types of businesses, mainly providing for the development of energy resources, or providing or maintaining the infrastructure for transporting and distributing energy products, particularly natural gas and oil.
Managed futures are a new type of professionally managed fund involving commodities and financial instruments that 1st appeared in 2009. Managed futures are accounts in which futures are traded by a commodity trading advisor (CTA). The CTA, through a power of attorney, trades on behalf of the investors. CTAs, who must be registered with the Commodity Futures Trading Commission (CFTC), generally work with broker-dealers and use proprietary trading systems to manage their clients' accounts. A managed futures account can obtain a higher investment return with a lower risk by hedging the portfolio. Investors can generally enter or exit a managed futures account once a month, usually with 5 business days notice to the fund or program.
Private equity funds are limited partnerships, where a private equity firm is the general partner and investment advisor to the fund. Private equity funds profit by infusing capital into private companies in the hope of turning them around and selling them later for a higher price. Private equity firms may also invest directly in private businesses by exchanging money for common stock or preferred stock that is convertible to equity. They also loan money in exchange for convertible debt. Private equity firms may provide venture capital to fund a potentially successful startup or try to improve the efficiency and growth of a small or medium-sized business with the goal of ultimately taking the firm public. Sometimes a public company will be taken private in what is called a leveraged buyout.
Although the return from private equity funds can be quite high, there is a considerable amount of risk. Furthermore, private equity funds have a term of at least 10 years and are highly illiquid investments. Hence, investors are primarily pension funds and university endowments that have a longer investment horizon.
Annuities are insurance products that provide income to the beneficiary, usually for retirement. The amount of income paid depends on the term of the annuity period, during which the beneficiary receives payments, the amount of premiums paid, and the investment returns of those premiums. Earnings are tax-deferred: no taxes are assessed on earnings during the accumulation period, which is the time when the premiums are paid. The annuity period can be based on a specific time or the expected lifetime of the annuitant, who is the one who receives the annuity. A fixed annuity pays a specified amount; a variable annuity pays a variable amount, depending on investment returns.
Some types of life insurance, referred to collectively as cash value insurance policies — whole life insurance, universal life insurance, and variable life insurance, and combinations thereof — are also types of funds. They all provide a death benefit and a cash value, that depends on the premiums paid and the income earned from their investment. Earnings grow tax-deferred. Some policies guarantee an interest rate on the premiums, in which case premiums are invested conservatively; other types of policies, such as variable life, are more aggressively invested in bonds, stocks, real estate, and other investments. The policy owner can surrender the policy for the cash value or borrow against the amount; any amounts not repaid reduce the death benefit. Some types of life insurance may even provide income while the insured is still alive. In some cases, such as viatical settlements, the owner can sell the policy to a third party for cash, usually to pay for the medical treatment of a terminal illness.
Managed Money Investment Accounts
Although there are a wide variety of investment funds, some investors have more specialized goals that are not achieved by any publicly available funds. To serve these clients, registered investment advisors can set up accounts that would appeal to these clients, where investment choices would not be restricted by the Investment Company Act. These accounts are generally only available to more affluent investors, since fees are based on a percentage of the assets under management.
Wrap accounts are managed by money managers for a specific client in which a wrap fee is charged that covers all the fees that would otherwise apply to the account, including administrative and management fees, and commissions for trades. The wrap fee is usually 1 to 3% of assets under management, paid quarterly. The minimum investment for most of these accounts ranges from $25,000-$10 million. The suggested investment horizon is 3 to 5 years. A broker oversees the money managers to help ensure that their investments are meeting goals.
There are also advisory accounts, of which there are 2 types: nondiscretionary accounts require that the investment advisor seek approval from the client before executing trades; discretionary accounts, by contrast, allow the advisor to trade securities without the client's ongoing approval. Nondiscretionary accounts generally use an asset allocation program that matches the client's investment goals and risk profile. The asset allocation model is generally specified in the investment policy statement. The asset allocation will generally change as the investor ages. In most cases, the asset allocation will become more conservative, with more money invested in bonds and other fixed income investments rather than stocks.
Another type of account, the individually managed account (IMA), has evolved to cater to high net worth individuals. The individually managed account is a separate account for a specific individual that is managed by an investment advisor according to the investment goals of that client and, to a certain extent, to manage the recognition of taxable gains and losses for a given tax year. The client receives one-on-one access to the advisor.
Another type of account that is closely related to the IMA (and is sometimes used synonymously) is the separately managed account (SMA), marketed by broker-dealers to more moderate income investors. The SMA pools the investments of several or many clients in a model portfolio that is not available as a mutual fund or ETF. The SMA can consider investments that would not be permissible for a mutual fund or other funds covered by the Investment Company Act. The broker-dealer picks money managers called subadvisors to manage the programs. SMAs generally charge a fee of 2% of assets under management; minimum investments are at least $100,000. Like the IMA, SMA investors have direct ownership of the securities held in the account, so they can control the tax recognition of income and losses.
Closely related to the SMA is the open architecture program, where investors have a greater choice of subadvisors and more flexible pricing.