Most investors make use of investment funds, and the market for these tools is huge, with trillions of dollars managed by funds globally across different strategies such as ETFs, investment trusts and hedge funds.
But what are investment funds and how do they work? In this article, we take a closer look at these important tools for the investment world and explain how you can incorporate investment funds into your portfolio to maximise your returns.
What are investment funds?
Investment funds are collective investment vehicles that pool money from multiple investors to invest in a diversified portfolio of assets. These assets can include stocks, bonds, commodities, real estate, and more. The fund is managed by professional fund managers who make investment decisions on behalf of the investors.
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These funds offer several advantages compared to investing directly in individual securities.
First, funds provide instant diversification, as they typically hold a large number of assets across different industries and sectors. This diversification helps to spread risk and reduce the impact of any individual investment's performance on your overall portfolio.
Second, funds are managed by experienced professionals who have in-depth knowledge of the financial markets and can make informed investment decisions. This expertise can potentially lead to better investment returns compared to individual investors who may lack the time, resources, or expertise to research and select individual securities.
Third, funds may help investors build exposure to different assets or asset classes they may otherwise not have access to, such as wind farms.
The types of investment funds
Investment funds come in various forms, each with its own characteristics and investment strategies.
Open-ended funds, also known as mutual funds, are the most common type of investment funds. These funds do not have a fixed number of shares and can continuously issue new shares to investors. Additionally, investors can typically buy and sell their shares directly with the fund at the fund's net asset value (NAV), which is calculated daily.
Closed-ended funds, as the name suggests, have a fixed number of shares. These funds raise a specific amount of capital through an initial public offering (IPO), and once the shares are issued, they can be bought and sold on a secondary market, such as a stock exchange.
Unlike open-ended funds, closed-ended funds do not continuously issue new shares or redeem existing shares. Instead, investors can buy or sell shares from other investors on the secondary market. The price of closed-ended fund shares is determined by supply and demand dynamics, which can result in shares trading at a premium or discount to the fund's net asset value.
Mutual funds are a type of open-ended investment fund that pools money from multiple investors to invest in a diversified portfolio of securities. These securities can include stocks, bonds, money market instruments, or a combination of different asset classes. Mutual funds are regulated investment vehicles that are subject to specific rules and regulations to protect investors.
Exchange-traded funds, or ETFs, are investment funds that are traded on stock exchanges, similar to individual stocks. ETFs can be open-ended or closed-ended, depending on their structure. However, most ETFs are structured as open-ended funds.
ETFs are designed to track the performance of a specific index, sector, or asset class.
These funds aim to replicate the performance of the underlying index by holding a portfolio of securities that closely matches the index's composition. Investors can buy and sell ETF shares on the secondary market, just like stocks, throughout the trading day.
Hedge funds are alternative investment funds that are typically only available to accredited investors, such as high-net-worth individuals and institutional investors. Hedge funds employ more complex investment strategies and are known for their flexibility in pursuing higher returns while managing risks.
How do investment funds work?
Investment funds are managed by professional fund managers who are responsible for making investment decisions on behalf of the fund's investors.
The investment decisions made by the fund manager are guided by the fund's investment objectives, which can vary depending on the fund's focus. For example, an equity fund may aim to generate long-term capital appreciation by investing in stocks, while a bond fund may focus on generating income by investing in fixed-income securities.
The net asset value (NAV) is a key metric used to determine the value of an investment fund. It represents the per-share value of the fund's assets after deducting its liabilities. The NAV is calculated by dividing the total value of the fund's assets by the number of shares outstanding.
Investors can buy and sell shares of investment funds through various channels, including fund platforms, brokers, financial institutions, and directly with the fund management company. The specific process may vary depending on the chosen investment platform or service provider.
Investment funds incur various expenses and fees, which are typically borne by the investors. There are three main types of fees investors need to keep an eye out for when looking at and comparing investment funds:
Management Fees: These fees cover the costs of managing the fund and compensating the fund management company or asset manager. Management fees are usually calculated as a percentage of the fund's assets under management (AUM).
Sales Charges or Loads: Some investment funds impose sales charges or loads, which are fees paid at the time of purchase or sale of fund shares. Sales charges can be front-end loads (paid at the time of purchase) or back-end loads (paid at the time of redemption).
Performance Fees: Some funds charge performance fees as a percentage of the profits earned each year over and above a set rate (usually compared to a benchmark).
Investors should consider the overall cost of investing in a fund, including the expense ratio, which represents the percentage of the fund's assets that are used to cover ongoing expenses. Lower-cost funds may offer a potential cost advantage, especially for long-term investors who prioritize minimizing fees and expenses.
How to choose the right investment fund
Selecting the right investment fund requires careful consideration of various factors, including investment objectives, risk tolerance, performance track record, fees, and other qualitative and quantitative measures.
The first step in selecting an investment fund is determining your investment objectives and risk tolerance. Consider your financial goals, time horizon, and willingness to take on investment risk. Are you seeking capital appreciation, income, or a combination of both? Are you comfortable with potentially higher levels of volatility, or do you prefer more conservative investments?
While past performance is not indicative of future results, analyzing a fund's performance over different market cycles can provide insights into its consistency and ability to deliver returns over time.
Compare the fund's performance against relevant benchmarks or peer groups to assess its relative performance. Look for funds that have consistently outperformed their benchmarks or demonstrated strong risk-adjusted returns.
Fees and expenses can significantly impact your investment returns over time. Carefully review the expense ratio of the fund, which represents the percentage of the fund's assets used to cover ongoing expenses. Lower-cost funds, especially index funds or passively managed funds, may offer cost advantages and potentially higher net returns.
In addition to the expense ratio, consider any upfront sales charges or loads, redemption fees, or other transactional fees associated with the fund. Understand the fee structure and assess whether the potential benefits of the fund justify the associated costs.
Investing in investment funds is an ongoing process, so monitor the performance of your investment funds regularly by reviewing the fund's performance against relevant benchmarks or peer groups. If a fund consistently underperforms or no longer aligns with your investment goals, consider reallocating your investment to other funds that offer better prospects or a better fit.
Jacob is the founder and CEO of ValueWalk. What started as a hobby 10 years ago turned into a well-known financial media empire focusing in particular on simplifying the opaque world of the hedge fund world. Before doing ValueWalk full time, Jacob worked as an equity analyst specializing in mid and small-cap stocks. Jacob also worked in business development for hedge funds. He lives with his wife and five children in New Jersey. Full Disclosure: Jacob only invests in broad-based ETFs and mutual funds to avoid any conflict of interest.
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