1.1 Investment Funds
Mutual Funds
A mutual fund, also called a Unit Trust, or an Open-end Trust, invests in a portfolio of stocks, bonds and other securities and is usually actively managed by a professional money manager with the aim of producing capital gains or income for the investors. When a mutual fund is actively managed, the management fee and hence overall expenses are much higher. Mutual funds give small investors the opportunity to invest in a diversified, professionally managed portfolio. A mutual fund’s prospectus can easily be found online and it will reveal the types of assets that the mutual fund invests in, the risk profile of the fund, it's performance history, minimum investment and its fees and charges. In contrast to hedge funds, mutual funds are not usually allowed to short sell or use large degrees of leverage.
Different mutual funds tend to charge investors in 2 different ways:
A high 'Front load' commission to buy a mutual fund unit (e.g. 5.75%) and then a low annual expenses, including the management fee (e.g. 0.25%)
A zero 'Front load' commission to buy a mutual fund unit but high annual expenses, including the management fee (e.g. 0.5% to 1.5% p.a. but as high as 2.5% p.a.).
The 1st high 'front load' is better in the long run if an investor is a passive investor (buy and hold). The 2nd zero 'front load' is better if an investor is an active trader (buying and selling on a regular basis).
Mutual fund types fall into 4 main categories
Money market funds - invest in high quality short term money market investments issued by US corporations, federal, state and local governments e.g. a treasury bill.
Bond funds - investment in bonds both government and corporate.
Target Date Funds (Sometimes called lifecycle funds) investment in a mix of stocks, bonds and other investments for people with particular retirement dates. Target date funds initially undertake more high risk, high return investing but as the target date (a person's retirement date) approaches, investing becomes more conservative and low risk (e.g. government bonds).
Stock Funds - investment in corporate stocks. These can focus in particular areas
Growth funds focus on stocks that, while not paying a regular dividend, are in a position to grow significantly
Income funds focus on stocks that pay a regular dividend
Sector Funds focus on specific industries
Index Funds - a special type of mutual fund tracking & duplicating a market index (e.g. the S&P 500). They typically have very low annual fees, sometimes as low as 0.04% Index funds are very popular. Due to duplicating the composition of an index, the return is exactly the same as the index itself. An investor in a fund that tracks the S&P 500 need only check the S&P 500 to see his fund's return. Index Funds - a special type of mutual fund tracking & duplicating a particular stock market index (e.g. the S&P 500). Index funds are very popular. Due to duplicating the composition of an index, the return is exactly the same as the index itself. Passive management so typically very low annual fees, sometimes as low as 0.04%. Very popular.
Mutual Index funds were created in 1976 by Jack Bogle who was tired of the high fees of actively managed mutual funds. Interestingly they were not initially well received by investors. A mutual fund invests in a portfolio of stocks, bonds and other securities. Usually actively managed by a professional money manager hence high fees. Investors can purchase mutual fund units from the fund itself or through a broker. They can sell their units back to the fund at anytime. Technically, mutual funds are limited companies or are trusts. Not traded on a stock exchange.
Open ended fund in the sense that the fund can reduce the size of the fund and its no. of units by buying back investors units. Can increase the size of the fund and its no. of units by taking new investors money and creating new units.
Value of a mutual funds units do not rise and fall during a trading day. Rather the value of a unit, reflecting the value of its underlying assets, is calculated when the markets close for the day.
Hedge FUnds
Hedge funds invest a pool of money obtained from investors. Hedge funds are much more lightly regulated by the SEC than mutual funds. The primary reason for this is that hedge funds are not open to the public but only to accredited investors (investors with a net worth of $1 m or a recurring annual income of more than $200,000 in the USA). In addition, depending on the hedge fund, the minimum investment is often $1 m. In contrast to mutual funds, hedge funds usually do not redeem (return) an investors investment on demand. Investors often have to wait to get their investment returned by a hedge fund. Many hedge funds undertake aggressive high risk, high return strategies. Nonetheless few hedge funds beat the market. Investors in hedge funds do however hope to gain from diversification. Hedge funds invest in a wide range of assets, including stocks, bonds, commodities, real estate and derivatives. Strategies can include leverage and short selling, investment strategies that mutual funds are usually not allowed to undertake. Hedge fund fees are considerable. There is a general annual management fee of 1% to 2% of fund assets. There is also a 20% to 40% performance fee usually of any profits above 5% which goes to the fund manager. The most common fee structure is 2/20, which means that the manager charges an annual 2% management fee and also keeps 20% of the profit earned in the fund (typically above 5%). In 2022 there were 3,841 hedge funds in the USA. Hedge funds are not open to the public but only to accredited investors. Minimum investment is often $1 m. Hedge funds legally are usually structured as limited partnerships. Hence a fund manager will act as a general partner. The fund’s investors will be limited partners. Hedge funds are not traded on the stock market. In contrast to mutual funds, hedge funds usually do not redeem (return) an investors investment on demand. Investors usually have to wait to be repaid their investment by hedge fund. Many hedge funds undertake aggressive high risk high return strategies. Strategies can include leverage and short selling, investment strategies that mutual funds are usually not allowed to undertake. Hedge fund fees are considerable.
A favourite techniques of hedge funds is short selling. They borrow shares today (from a stockbroker), sell them today then buy them back later at a (hopefully) lower price. The short seller is expecting the share price to drop.
Investment Trust
Investment trusts are public limited companies that invest in other companies (both public and private), bonds, real estate and other assets. They are actively managed. Investment trust shares are traded on the stock market like normal shares. Investors can see their share price at any time of the day and buy and sell them in the same way as normal shares (through a stock broker who either buys and sells his own inventory of shares or buys and sells on the stock market). They are closed ended, in the sense that there is a fixed number of shares in issue. New shares can not be created. Investment trusts are very popular in the UK, less so in the USA although in the USA Real Estate Investment Trusts (REITS) are very popular. Interestingly, investment trusts often trade below the value of their net assets (their NAV). Net Asset Value (NAV) = Total Assets minus Liabilities. Investment trust shares are traded on the stock market. They are PLCs that invest in other companies (both public and private), bonds, real estate and other assets (even farmland and art). Can be widely diversified but can also focus narrowly on particular areas. Actively managed hence high annual expenses. Closed ended - a fixed number of shares in issue. New shares cannot be created. Historically have often trade at a discount to their Net Asset Value.
Dividend Yield
Dividend yield is a ratio that shows how much dividend is paid out annually compared to the price of the share. New companies (growth stocks) typically pay no dividends. Older more established companies (Blue chip) tend to pay regular dividends. Historically dividend yields for public limited companies range from 2% to 5% for the S&P 500.
ETF
ETF means Exchange Traded Funds. Very similar to Index funds (both ETFs and Index funds have a passive investing strategy in that they both track & duplicate a market index e.g. the S&P 500). This means much lower fees. However, unlike a Mutual Index fund (which is not traded on a stock exchange but only bought after close of stock market trading from the Mutual Index fund itself), ETFs are traded on a exchange and can be bought throughout the trading day (although technically they are not a share). Generally low management fees of 0.25% or even as low as 0.03%. ETFs can invest in shares, bonds, commodities and currencies. ETFs are passively managed (like Index funds). ETFs are traded during the day on exchanges (unlike index funds).
ETFs and other funds publish various measures of dividend yield, so it is important to understand the different types.
Trailing Dividend Yield is popular. The previous 12 months of dividends added together and divided by the most recent NAV.
Forward Dividend Yield (current yield, indicated yield) is the most popular yield given by funds because it gives the highest figure. Forward Yield takes the most recent dividend paid (dividends are paid quarterly) and assumes it will remain constant over the coming year (the most recent dividend is multiplied by 4 and then divided by the most recent NAV).
Distribution Yield shows actual cash flows to investors. In other words, dividend less expenses and taxes payable by the ETF before the investor receives his net dividend. Usually calculated as the sum of all net distributions paid to investors over the past 12 months, divided by the ETF’s most recent month end NAV.
Expense Ratio
How much does investing in a fund cost? One measure is the Expense Ratio
Expense ratio = Operating fees + Management fees
Operating fees - marketing, legal, auditing, customer service and other administrative costs.
Management fee - expenses such as hiring the portfolio manager and investment team. These can be 0.5% and 1% of the fund's assets.
Mutual funds actively buying and selling securities will typically carry expense ratios between 0.50% and 1.50%. However that the 'expense ratio' does not include brokerage fees (the cost a fund pays to physically buy and sell shares on a stock exchange).
Expense Ratio: Actively managed fund 0.5% to 1.5% (exceptionally 2.5%), Passively managed as low as 0.04%
Brokerage fees e.g. trading commissions buying and selling shares for the fund. These are fees the fund pays buying and selling shares. Brokerage fees can be as low as 0% (Robinhood sells your data to make money) or as high as 2%.
Efficient Market Hypothesis
The Efficient Markets Hypothesis (EMH) is primarily derived from Eugene Fama’s 1970 book, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Fama argued that it is virtually impossible to consistently “beat the market.” An investor may get lucky and make huge short-term profits but over the long term he cannot expect to make a return that is substantially higher than the market average. Efficient Markets Hypothesis argues that shares traded on stock exchanges are fairly valued meaning it is impossible for investors to buy shares that are undervalued or to sell their shares at an overvalued price. According to Efficient Markets Hypothesis the share price reflects all information and consistent alpha generation is impossible. The only way an investor can generate higher returns than the average market return is by taking a higher risk. Hence efficient market hypothesis argues that investors and professional fund managers cannot consistently beat the market. Investors therefore would do better investing their money on a passive non actively managed low cost fund (such as an Index Mutual fund or an ETF).
Efficient Markets Hypothesis comes in 3 strengths
Weak Form Efficiency argues that the share price reflects all historical information relating to a share but not new information. Therefore, an investor cannot outperform the market by analysing a stock's past performance but potentially could do so by analysing new information.
Semi-Strong Form efficiency argues that the current share price of a stock adjusts rapidly to the release of all new public information. Hence, an investor cannot outperform the market by analysing the stock (e.g. analysing its current balance sheet and all current news relating to the stock) because the stock price already incorporates all publicly available information. An investor could however still outperform the market by analysing private information (insider trading).
Strong Form Efficiency refers to a share price fully reflecting not only all publicly available information (the semi-strong form) but also all private information (insider information). In such a market, it is impossible to make any gains above the market by analysing the stock (both quantitative e.g. analysing its balance sheet and qualitative e.g. all news relating to the stock) even with private information, as the stock price already reflects all information, both public and private.
Hence efficient market hypothesis argues that investors and professional fund managers cannot consistently beat the market. Investors therefore would do better investing their money on a non actively managed fund (such as an Index Mutual fund or an ETF) that mirrors a market index e.g. the FTSE100.
Many shares & bonds are rarely bought and sold (lack liquidity). Sellers cannot find buyers and buyers cannot find sellers.
Market makers solve this problem by buying shares & bonds from sellers on the stock market who otherwise would not find a buyer. They also buy shares and bonds that lack liquidity and hold these as inventory to later sell to buyers. Market makers are typically large banks or financial institutions but also sometimes stockbrokers. They make their profit from their bid ask spread. The difference between their bid price (lower price they are willing to buy at) and their ask price (higher price they are willing to sell at) is called a bid ask spread and is their profit. The bid/ask spread when buying or selling shares, Investment Trusts, ETFs & bonds is normally expressed as percentage of the ask quote (the price a broker or market maker will sell for).