It would be foolish to shop for a new automobile without understanding the basic difference between a sports car, an SUV, a pickup truck, and a minivan. It would be equally foolhardy to shop for a new financial product without understanding the difference between a mutual fund, ETF, VC fund, and hedge fund. If you are in this camp, this article will get you up to speed.
Mutual Funds are highly regulated entities that invest in other stocks or bonds. They purchase a pool of stocks or other securities and sell shares of that pool to investors.
This structure has its advantages and its disadvantages to investors. Big advantages include:
- Quick and easy diversification for individual investors. A small-time investor can acquire an effective position in hundreds of different companies through a small purchase of just one fund. Doing this oneself would be time consuming and expensive.
- Cost efficient. Mutual funds can split the fixed costs of purchasing investments - such as research and trading costs - across tens of thousands of different shareholders. If you were doing this on your own, you would only get to share the costs with yourself (or maybe your spouse) and your costs would likely be much higher.
- Easy to get in and out. Mutual funds are required by law to purchase and redeem shares at a price equal to its Net Asset Value (NAV). This requirement is known as "providing daily liquidity."
Mutual funds come in two varieties: actively managed funds, and passive funds that are more commonly known as "index funds." As you might expect, actively managed funds usually employ a portfolio manager and several investment analysts to do research to try to uncover investments that will "beat" the market. Passive funds just buy every stock in a large benchmark like the S&P 500 to try to match the market's overall performance.
A big disadvantage to actively managed funds is that it is expensive to try to beat the market:
- The mutual-fund manager and research team are usually very highly paid, which necessitates charging a significant fee to shareholders. The fees that mutual funds charge can seriously lower your returns over time.
- The structure of the mutual fund can actually hurt its chances of out-performing the market. Since mutual funds are required to provide daily liquidity, they must always have cash ready to give to any shareholders that might want to leave the fund. This is an expensive distraction.
- The high-priced manager and research team usually fail to add much value by being there - most mutual funds generate worse performance than you could get by randomly buying and holding a diversified portfolio of stocks. For instance, in its latest survey of actively managed mutual funds, Standard and Poor's found that an un-managed index of the overall US stock market outperformed 68% of US equity funds in the five years ending July 2012.
Index funds do not even try to beat the market, so they tend to have much lower fees. According to data from the Investment Company Institute, fees for actively-managed funds averaged .93% of assets in 2011, while fees for index funds averaged only .14% of assets.
For more on the challenges faced by actively-managed mutual funds, check out What Mutual Funds Look Like Next to Their Benchmarks and The Age of the Mutual Fund is Over.
Exchange Traded Funds (ETFs)
An ETF is a sort of hybrid between an individual stock, and an index mutual fund. Like stocks, ETFs are traded on an exchange in real-time. Like mutual funds, each ETF is a collection of many individual stocks or bonds. ETFs are usually not actively managed, but instead seek to replicate the returns of a passive benchmark like the S&P 500. Because of there passive nature and because of the efficiency of the structure, they are usually lower-cost than mutual funds. For more on ETF universe see our primer on ETFs.
A disadvantage of ETFs relative to mutual funds is that with ETFs there is no requirement for "daily liquidity." An investor who wants to sell an ETF has to go onto the stock market and accept the best price a purchases is willing to give. However, an ingenious future of ETFs called a "creation unit" keeps the market price of highly liquid ETFs (ones in which there are active buyers and sellers) very close to its net asset value. This can actually turn the disadvantage into an advantage, since with an ETF you can buy or sell at any time of the day, whereas with mutual funds you have to transact at the end of the day. This unique creation-redemption mechanism also makes ETFs a more tax-efficient structure than mutual funds, because mutual funds are forced to realize tax gains whenever they sell positions (which they might have to do to meet redemption requests), whereas ETFs are not.
Hedge funds are like less regulated versions of mutual funds that charge a lot more. Because hedge funds are only available to "qualified investors" that meet certain financial requirements, and because they do not need to provide investors daily liquidity, they are allowed to do things that mutual funds cannot:
- They can use leverage (borrowed money) to make investments, thereby magnifying their returns if they are correct in their bets.
- They can short-sell securities to profit from a fall in a stock's price. Short-selling involves borrowing the shares of a stock from a broker, selling those shares, and then purchasing them at a lower price in the market to pay back the loan.
- They can use derivatives like futures contracts, options, and credit default swaps. Derivatives are financial contracts whose value is based on the value of something else, like a stock, bond, or commodity.
Hedge funds typically charge clients 2% of assets and 20% of all profits. One ostensible reason that hedge funds are able to charge such higher fees is that they can be what is called "absolute return vehicles." This means that while mutual funds tend to steer quite closely to a benchmark like the S&P 500 index, hedge funds are more likely to try to produce returns in both good and bad markets. They claim to be able to deliver what is called "true alpha" (returns that derive from skill rather than just accepting the risk of investing).
One problem with hedge funds is that many are not as "market neutral" as they would like you to believe. Hedge funds tend to be more "long" than they are "short", meaning that they usually have a quite positive exposure to the market, just as mutual funds do. But given their much higher compensation structure, hedge funds have to achieve much more positive results than mutual funds to in order to deliver the same result to their clients, since so much more money is going into the pockets of the investment team.
Research shows that while some top hedge funds have been able to generate consistently impressive performance numbers, as a whole, the industry has failed to deliver. Studies show that while some individual funds may be stellar, whatever "alpha" the industry has produced as a whole has gone into the pockets of hedge-fund companies themselves, rather than their investors (see "Do Hedge Funds Hedge" by Cliff Asness of AQR Capital Management). Unfortunately, the funds that are obviously top tier are likely closed to individual investors.
(for more on the questionable justification of hedge fund fees, see Investment Products Formerly Available Only to the Ultra-Rich? I'll Pass).
VC funds are like hedge funds that invest exclusively in very early stage startup companies. They also typically charge a "two and twenty" fee of 2% of assets and 20% of any profits the fund generates. VC funds tend to be even less "liquid" than hedge funds, since early-stage companies can sometimes take the better part of a decade or more (if ever...) before they hit any kind of IPO or "exit event" that lets early investors get their money back.
VC returns tend to be dominated by extremely rare "home runs", like a Google or a Facebook, while the majority of investments fail. This produces an extremely wide distribution of returns. Funds that were able to invest in the huge successes do very well, but the average firm again falls short of what investors were hoping for. Over the past decade, overall VC returns have been flat, despite a few big wins. Research shows that top VC firms are able to generate consistent positive returns -- but most of these top funds will only take money from large institutional investors like pension-funds.
Private Equity Funds are like hedge funds that invest in companies which are not publicly traded. Some private equity firms specialize in "buyouts" of publicly traded companies, a strategy in which a public company is "taken private" in the hope of improving its operations or financial structure and selling it again (either in the public markets or to another private buyer) at a higher price.
Like VC firms, there is a wide distribution of returns within the private-equity world, with some funds generating extremely impressive returns but others failing to meet their expectations. Unfortunately, the top tier of private-equity firms is likely off-limit to all but the highest net-worth of individual investors.
Summing It Up
The major kinds of funds available to investors include mutual funds, ETFs, hedge funds, venture capital funds, and private-equity funds. However, the latter three are likely only available to accredited investors that have over $1 million in assets or an income over $200,000.
Whether you are an accredited investor or not, the major decision you have to make is not necessarily mutual funds vs. etfs or etfs vs. hege funds, but is fundamentally how active of a fund you want. While there is strong evidence that some managers are capable of "beating" the market, there is also very strong evidence that, on average, active managers as a whole fail to beat the market over long periods of time (in fact, this is almost a mathematical certainty if you assume that the market return is made up of a collection of average investor returns, that most investors are professionals, and that professionals charge fees).
So the active vs. passive decision comes down to whether you think that you can pick a fund manager that is going to be consistently good over the next few years. Unless you have a lot of money or unusual access to a top fund, the brunt of the evidence would seem to indicate the answer to this question is probably not. That is why the IvyVest model uses ETFs. Though there is at least one situation when active investing may beat passive investing.
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