Investment Funds

On 08/20/2010, in Mutual Funds, by Jordan Wilson

Investment funds are collective investment schemes.

That means that many investors aggregate their money in a single investment vehicle.

In theory, aggregation allows some or all of the following to 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.

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 may have subsequent public offerings. But normally there are no other issues after the IPO has been completed.

The CEF is listed on a stock exchange and all acquisitions or dispositions by investors takes place in this secondary market. Transactions occur during normal trading hours of the exchange.

Note that 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 liquidate the company itself.

The value of shares is determined in two ways.

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 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 point with NAV is the market value of the investment portfolio. As the portfolio is made up of common shares, bonds, money market instruments, etc. whose own valuations fluctuate daily, an investment 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.

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 stock, the more competition there is for available shares. This stronger demand will increase the share price above the NAV value.

The difference between the NAV and market price of the shares is known as the “premium”.

Other CEFs may trade below their NAV. This is because there are more shareholders who wish to sell (supply) than there are new investors wanting to buy (demand).

Why are there premiums and discounts for investment portfolios?

The main reasons are twofold.

Investors look at the securities within CEF portfolio and believe these investments will increase or decrease. Based on perceptions about the returns on the investment portfolio, investors will be bullish (optimistic) or bearish (pessimistic) about the future.

Secondly, investors look at the 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.

As an example, 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 is no premium or discount associated with the share price.

Shares of an open-end fund are not traded on a stock exchange. Investors purchase shares directly from the fund. As there is no secondary market, the fund itself must buy back any shares that investors wish to sell. This is known as “redemption of shares”.

For most funds, the NAV is calculated daily and investors purchase or redeem shares at the close of day NAV. There are some funds though that 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 in these funds. 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 of the fund.

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 much like a closed-end investment 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 a specific index or benchmark. There are many different ETFs that track a wide variety of areas.

For example, an ETF may track a: country (IShares MSCI Brazil Index); region (Vanguard Emerging Markets Stock ETF); stock exchange index (SPDR for the Standard & Poors 500 Index); industry sector (United States Oil); commodity (SPDR Gold Shares).

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.

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.

Because 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 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 actively managed by fund managers, 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 (i.e. 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 sense for investment funds. Not too deep, but an idea of what they are and how they differ from one another.

I am a big proponent of using mutual funds and ETFs in one’s investment portfolio.

We will consider these two investment funds in greater detail over the next week.

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