To date, we have reviewed the major asset classes: cash and cash equivalent; fixed income; equity or common shares. There are a variety of lesser asset classes, as well as sub-classes within each class. We will cover some of these in time.
You can invest in assets of each class individually or via collective investment schemes. In the latter, many investors aggregate their money in a single investment vehicle. These collective schemes are generally called investment funds.
In theory, aggregation allows some or all of the following benefits for individual investors: a simple way to create and maintain an investment portfolio; better portfolio diversification through asset classes and time; access to investments that cannot be bought by small investors; improved liquidity; fund management by investment professionals; economies of scales on expenses that reduce costs allocated to any one investor; consolidation of tax information.
Because of these potential benefits, most investor portfolios should be comprised primarily of investment funds.
Today we will review four types of investment funds.
Closed-End Investment Fund (CEF)
This fund is established as a corporation with a limited number of shares initially issued to investors via an Initial Public Offering (IPO). The proceeds are then invested according to the objectives and fund policies as stated in the prospectus.
Occasionally CEFs have subsequent public offerings. But normally there are no other issues after the IPO.
The CEF is listed on a stock exchange. Share acquisitions or dispositions by investors takes place in this secondary market. Transactions occur during normal trading hours of the exchange.
Shares are not redeemed by the company. An exception would be if the CEF decides to either reorganize and redeems a portion of shares or liquidates the company itself.
Share value is determined in two ways.
Net Asset Value
Share price is based primarily on the net asset value (NAV) of the investment fund. The NAV is the value of the fund’s investment portfolio (its only assets) less any liabilities that exist. To calculate the NAV per share, divide the net assets of the fund by the number of outstanding shares.
For example, Omega Investment Fund has an investment portfolio with a market value of $100 million, short term liabilities of $1 million, and 9 million shares outstanding. The NAV of Omega’s shares is $11 per share.
The key to NAV is the market value of the investment portfolio. The portfolio is made up of common shares, bonds, money market instruments, etc. As these asset valuations fluctuate daily, a fund’s NAV will also change daily.
In our example, Omega’s NAV is $11 per share. If this was a real company and I checked the actual share price, I would expect to see it somewhere around $11 per share.
Somewhere, that is, but not exactly.
Premium or Discount
The second component of a CEF’s share price is based on investor supply and demand.
Investors who want the stock must buy it on the secondary market. The greater the number of investors who want the CEF, the more competition for available shares. Stronger demand than supply will increase the share price above the NAV.
The difference between the NAV and market price of the shares is known as the “premium”.
Other CEFs may trade below the NAV. This is because more shareholders wish to sell (supply) than there are new investors wanting to buy (demand). In this case, shares trade at a “discount” to NAV.
Why Trade at Premium or Discount?
Why are there premiums and discounts for mere investment portfolios?
Investors look at securities within a CEF portfolio and believe these investments will increase or decrease. Based on perceptions about future returns on the portfolio, investors will be bullish (optimistic) or bearish (pessimistic). The more bullish, the greater the demand and the greater the premium. The more bearish, the opposite.
Secondly, investors look at fund management. If management is seen as strong, investors believe that management will find new investments that will bring superior returns versus other funds. This will also create a premium.
Consider Warren Buffett. If Mr. Buffett managed a CEF, I expect there would be a nice premium on the share price. And with Berkshire Hathaway (a conglomerate, not a CEF), there is usually a healthy premium to the share price.
Note that these are the same principles that drive the share price of operating companies.
Open-End Investment Fund (Mutual Fund)
Mutual funds, as the formal name indicates, are open-end funds.
Like closed-end funds, a new mutual fund issues shares (or units) to investors and invests the proceeds according to the fund’s stated objectives. However, a mutual fund continuously sells new shares to the public. The issue price of the shares is equal to the NAV of the fund.
There should be no premium or discount associated with the share/unit price.
Open-end funds are not traded on stock exchanges. Investors purchase shares directly from the fund. With no secondary market, the fund itself must buy back any shares investors wish to sell. This is known as “redemption of shares”.
For most funds, the NAV is calculated. Investors purchase or redeem shares at the close of day NAV.
A few funds do not allow purchases or redemptions on a daily basis. Investors may only have the option of buying or selling on a weekly, monthly, or quarterly basis. This can create liquidity problems for investors. Be certain you know the frequency of possible transactions before investing in any funds.
Over time, an open-end fund may become a “closed fund”. Do not confuse a “closed-end fund” with a “closed fund”.
A closed fund is an open-end fund that has been shut to new investors. Closure may be permanent or for a temporary period. While the fund may not accept new investors, often existing investors can still acquire additional shares.
The most common reason for a fund to close is that its assets under management has become too large for the fund to properly invest under its stated objectives and strategies.
Exchange Traded Fund (ETF)
An ETF is like a closed-end fund in that it trades on a stock exchange and does not issue new shares to the public.
An ETF is a security that tracks, or performs against, a specific index or benchmark. There are many different ETFs that cover a wide variety of areas. Many ETFs simply passively follow their benchmarks as closely as possible.
An ETF may track a: country (iShares MSCI Brazil Index); region (Vanguard Emerging Markets Stock ETF); stock exchange (SPDR for the Standard & Poors 500 Index); industry sector (United States Oil); commodity (SPDR Gold Shares).
Some ETFs are actively managed as they attempt to outperform their benchmarks. For example, the PowerShares Actively Managed Low Duration ETF.
ETFs trade like shares and there is no NAV calculation.
In attempting to replicate an index or benchmark, there are a few different methods employed. ETFs may hold the index fully in its proper proportion. This may be accomplished for smaller indices such as the Dow Jones 30.
ETFs may use representative sampling techniques to replicate performance with less than 100% of the index components.
ETFs may also utilize derivatives such as options, futures, and swaps, to try and mirror an index’s performance or synthetically create portfolios.
With passive index ETFs, how the fund replicates its benchmark and its tracking error are important considerations.
Hedge Fund
A hedge fund can be a variety of investment creatures. Some more scary than others.
In general, a hedge fund is a pooled structure of investments that uses a wide variety of strategies to achieve its stated investment objectives.
Sounds much like a CEF or mutual fund.
The main difference between hedge funds and other funds is the level of regulation.
Hedge funds are intended for (supposedly) sophisticated investors who understand the world of investments. Especially the concept of investment risk.
In many jurisdictions, there are rules governing who is and is not a sophisticated investor. Usually this is linked to the investor’s net worth, annual earnings, investment experience, etc.
As hedge fund investors are supposed to be experienced and knowledgeable, hedge funds invest in a wide variety of investments and utilize strategies and tactics not usually found in mutual funds. For example, hedge funds may take short positions, invest in derivatives, and utilize leverage.
A common perception of hedge funds is that they are out of control investment vehicles, engaging in high risk (hopefully high reward) activities.
Some hedge funds are indeed very risky. But other hedge funds use derivatives, short sales, etc. to reduce portfolio risk. In fact, the term “hedge” is used for activities that attempt to decrease investment risk in an asset or portfolio.
If you ever get to the point where you want to invest in a hedge fund, make sure you read the prospectus or offering documents very carefully. Know the level of risk that the fund will accept in their investment plans.
Another consideration with hedge funds is the cost.
Hedge funds tend to be extremely actively managed, so the management expense ratio is usually high relative to other funds types. Not always, some open and closed-ended funds also require extensive management, but usually.
And it is not uncommon to find “performance fees” (also called “incentive fees”) paid to fund managers for returns in excess of agreed upon hurdle rates (e.g., benchmark or minimum return). These can be extremely generous, so know in advance what you might be paying to the fund managers for their efforts.
Strangely, while I have seen many performance fees in hedge funds for superior returns, I have yet to come across any funds that offer refunds for underperformance. Funny how it always works that way.
I believe management expense ratios and other fund costs should be the key consideration when selecting any type of fund. As a result, we will spend some time a little later on this topic.
That should give you a quick sense for investment funds. What they are and how they differ from one another.
I am a big proponent of mutual funds and ETFs. Especially for smaller investors, the potential benefits are often very worthwhile. We will consider these two investment funds in greater detail over time.
