Investment funds are financial funds that pool capital from many investors into a single pot, so to speak. The purpose of an investment fund is to allow each person to hold a stake in a set of securities. Rather than purchases the individual securities in the fund on their own.
This method of investing makes the practice of buying into a large number of securities affordable. Many times, such funds come in low-risk packages. Especially compared to the market at large, as many funds track positive returns in the long-term. This makes funds even more attractive to the average investor. (Note that this doesn’t mean every fund is low-risk or generates returns. It’s important to do your homework if you’re looking to invest in any security).
An investment fund is like a lasagna. You pile the ingredients into the dish in layers, and then every person at the table gets a slice with every ingredient. Depending on the type of fund, these layers may include of stocks, bonds, money markets, or other securities.
Open-end and closed-end funds are one way to categorize many investment funds. Typically, open-end funds are mutual funds that trade once a day based on the Net Asset Value (NAV) of the fund. By contrast, closed-end funds trade more like stocks and are not limited to the NAV.
Index funds are low-risk “baskets.” They contain most or all of the funds within a specific index, like the S&P 500. An index fund approach makes investing in a diversified portfolio of thousands of stocks affordable for the everyday investor. Famous investors like Warren Buffet champion this type of fund. They celebrate it for being more practical than handpicking every stock within an index.
ETFs are exchange-listed securities that track an index (which makes many ETFs a type of index fund by definition). These funds trade like stocks and carry many of the freedoms of stock market investing. They also carry a few risks. However, ETFs are more cost-effective and liquid than many other types of funds. And they’re usually lower risk than picking securities by hand.
Mutual funds are professionally managed portfolios that trade once per day based on the Net Asset Value of the fund as a whole. Their limited trading window makes them a good choice for skittish investors. However, in the case of a major market crash, it may be too late to back out without damage. Furthermore, because many mutual funds are managed hands-on, they come with higher expense ratios that eat into profits.
The Basics of an Investment Fund
One way to illustrate an investment fund is to think about making a lasagna. First, you put down the noodles. And then your meat or vegetable filling. And then your tomato sauce, and then your cheese, and repeat. Once you bake and serve the lasagna, every person at the table gets a little bit of everything. In the same way, an investment fund “stacks” various securities on top of each other. And then each investor purchases a slice of the pie.
Depending on the type of fund, the securities involved may be stocks, bonds, money markets, or more. There are several types and subtypes of investment funds. But all share a similar purpose: They intend to generate returns. While the size of the return varies, each is investing to make money on their capital. Investment funds, when run properly, are just another vehicle to build wealth.
It’s important to note that investment funds, like any financial vehicle, should be thoroughly vetted. The fund should be clear about its goals and transparent about its financial transactions in its prospectus. (A prospectus is an informational statement disclosing various metrics about the fund.)
Before we leap into the types of funds, we’re going to cover two essential classifications: open-end and closed-end funds. Knowing the distinction between these will help you better understand the main funds we’re going to discuss later.
Open-End vs Closed-End Funds
One way to categorize various mutual funds and ETFs is with open-end and closed-end funds.
Open-end funds are typically mutual funds offered by mutual fund groups, such as Vanguard, Fidelity, and others. These groups buy and sell their shares at the end of the trading day based on the closing Net Asset Value (NAV). The shares of the fund are priced according to the NAV.
Closed-end funds, on the other hand, trade more like shares of stock. For instance, they:
- Hold an IPO (initial public offering) before listing on an exchange
- Can be bought and sold through a brokerage account
- Are marginable
- Can trade intraday on various orders such as limit, stop, and market orders
An important distinction between open- and closed-end funds is that closed-end funds are not limited to the NAV pricing model. A closed-end fund is allowed to trade above its NAV (called trading at a premium) or below its NAV (referred to as trading at a discount).
Now that we know the distinction between open- and closed-end funds, we can discuss some of the most common funds. Index funds, ETFs, and mutual funds.
First, index funds are not their own type of fund. But they are integral to understanding many mutual funds and ETFs. So we’re going to cover them first.
They hold a unique place in the market as “baskets” that contain most or all of the securities in a specified index. For instance, many index funds track the performance of the S&P 500 Index. This means that these funds use the S&P 500 as an “underlying index.” They use it to determine which securities the fund should buy and in what amounts.
This approach makes it easy and affordable for individual investors to purchase shares of hundreds or even thousands of companies without hand-picking each security. Furthermore, index funds are a good way to buy a representative sample of an index without spending the exorbitant amount of money required to buy one share of every stock within an index.
Warren Buffet himself, among many other famous investors, recommends index funds on this very basis. He has stated that it makes more sense to purchase a slice of a fund holding every security, rather than a slice of every security within an index.
As a result of their basic makeup, index funds are some of the most diversified, low-risk investment vehicles available. Typically, they also offer steady returns, either through dividends or by producing interest. By not limiting their scope to a few companies or a single asset class, investors can bet on long-term market trends. These are more profitable in the long run than most handpicked portfolios.
ETFs (Exchange-Traded Funds)
An ETF is an exchange-listed security that tracks an index comprised of individual securities. Such as the S&P 500 or the Nasdaq. When you purchase a share of an ETF, you’re not picking out the securities you wish to buy. Instead, you decide which asset class(es), sector(s), or indices you’d like to invest. Some ETFs also follow particular strategies by choosing a sampling of an index to follow.
ETFs can own thousands of stocks in a single fund. Or they can limit to a few dozen within a given sector or industry. In the United States, most ETFs are open-end funds. This means that they don’t limit investors.
The main difference between an ETF and a mutual fund, which we will cover next, is that ETFs list on exchanges and trade intraday, like stocks. This can be both a blessing and a curse for many investors.
For instance, incredibly risk-adverse investors who notice shares of their ETF slipping with a market crash can sell before the day’s close. However, the ability to access the market at any time leads to trading on impulse and emotion, rather than attempting to weather the storm.
Furthermore, ETFs tend to be more cost-effective and liquid than many other funds on the market due to different capital gains regulations. Typically, they cost less tax-wise in a given year than many mutual funds, and they often carry a smaller expense ratio, as well. This is the result of many passively ETFs, which leads to fewer management fees.
However, there are a few actively managed ETFs in which the portfolio managers handpick securities to buy and sell throughout the day. These ETFs tend to cost more overall. And it’s no guarantee that you’ll generate gains over passive ETFs. This is partially the result of higher expense ratios as well as the fact that they are more susceptible to human judgment and impulse.
Main Types of ETFs
There are several types of ETFs on the market with each based around different goals. Some intend to turn a profit through capital gains, while others are based around supplying dividends to investors. Still others hedge against various risks in investors’ portfolios.
A few of the most common ETFs include:
- Bond ETFs focus on investing in various types of bonds across or within certain sectors
- Industry ETFs track a stated industry – financial, technology, etc.
- Currency ETFs put their funds into foreign (non-USD, for our purposes) currencies
- Commodity ETFs invest in various physical commodities, such as gold or oil
Pros and Cons of ETFs
Overall, ETFs offer more choices to their investors when it comes to trading shares. This is because investors do not have to buy or sell in a set time in the trading day. They also have smaller or no investment minimums than many types of funds.
Furthermore, it’s possible to profit on an ETF when the market plunges, as some ETFs (called inverse ETFs) trade on principle of shorting the stocks in their portfolio.
However, just as with mutual funds, not every ETF is profitable. Because they can list on exchanges, they have to meet certain standards – but management fees and high expense ratios can eat into an investor’s profits, just as with any fund.
A mutual fund is another type of financial vehicle that a professional money manager organizes. The individual or firm in charge is responsible for allocating the fund’s assets in a way that produces profit (income) for the fund’s investors. The purpose of a mutual fund is to give individual investors access to professionally managed portfolio of securities, rather than throwing them to the wolves (or into a pit of hungry financial advisors).
As with an ETF, the portfolio of a mutual fund should match the investment objectives – read: which indices, assets, or sectors make up the portfolio, and in what percentages. It’s possible for a mutual fund to contain hundreds of individual securities at once or only a few dozen. The makeup of a mutual fund means that every shareholder has a stake in the fund’s performance (losses and gains) in the same proportion they’re invested.
Typically, mutual funds invest in more than one type of security at a time – for instance, a single fund may hold stocks, bonds, and money market securities. Therefore, you can calculate a mutual fund’s performance by looking at each underlying investments’ performance.
Unlike ETFs, mutual funds change price – and hands – only once per day. We mentioned above that open-end funds trade at the end of the trading day based on the NAV (Net Asset Value) of the fund. Mutual funds trade the same way. You can calculate the share price of the fund according to the NAV after markets have closed.
It’s important to note here that in an actively managed mutual fund, the manager(s) can trade assets within the fund intraday. However, you cannot make money trading shares of the whole fund throughout the day.
As a result, mutual funds are usually poor investments for day traders, but like ETFs, they are popular with many retirement funds, as they tend to generate average to generous returns on investment over a period of years.
Main Types of Mutual Funds
Mutual funds come in three basic flavors:
- Open-end funds generate and remove shares due to investor demand
- Closed-end funds maintain a fixed number of shares that trade only as available
- Unit Investment Trusts (UITs) are static portfolios with no management
Pros and Cons of Mutual Funds
The main advantage of mutual funds is that they allow everyday investors to (more or less) affordably purchase their way into diversified, professionally managed portfolios. Over time, they can generate steady gains on investment within the fund.
However, these benefits come at a steep cost: most actively managed mutual funds charge high fees that can negate returns.
Furthermore, mutual funds, unlike ETFs, are not the most tax-efficient investment vehicles. With a mutual fund, the money invested is only tax-exempt so long as the money remains within the fund. In the case that a mutual fund sells a particular security at a profit, the law requires that the money is reimbursed to the shareholders. They must then pay taxes on their capital gains – whether they wanted the gains or not.