The Fabulously Fun World of Funds
11/10/2010 2:45 pm EST
John Heinzl, reporter and columnist for GlobeInvestor.com, discusses key differences between different types of funds.
You know all about mutual funds, and quite likely own some in your portfolio. You’re also probably familiar with exchange traded funds, which combine the diversification of mutual funds with the trading flexibility of stocks.
But do you know the difference between a segregated fund and a closed-end fund? And what, exactly, is a hedge fund? Hint: It’s not money the neighbors pool together to keep their bushes looking neat and tidy.
Well, wonder no longer. Today, we’re taking a short walk through the fabulously fun world of funds. So grab hold of the rope, kids, and let’s begin.
Mutual funds are the most popular investment vehicles out there, with Canadian assets under management of about $720-billion, according to Investor Economics.
By investing a pool of capital in stocks, bonds and other assets, mutual funds provide benefits such as diversification, professional management, and liquidity. They’re a great way for people with limited funds to get started in investing, but management costs can be high, and you also have to watch out for front- and back-end “loads.” Most mutual funds are open-ended, meaning the fund doesn’t have a set number of shares. Rather, it issues new shares and redeems existing ones daily, at the net asset value of the fund.
Exchange Traded Funds
Like mutual funds, ETFs are also open-ended. The difference is that ETF units can be bought and sold throughout the day on a stock exchange, whereas mutual fund orders are processed after the close of trading based on the day’s final prices.
Another difference is that most ETFs are designed to passively track an index, which keeps their costs low relative to active mutual funds that pay a manager who tries to beat the index (most don’t). Because they’re cheaper and more flexible than mutual funds, ETFs are growing in popularity, but the ETF industry is still only about one-twentieth the size of the mutual fund industry.
Segregated funds are issued by insurance companies and their chief selling point is safety. They’re called “segregated” because the fund’s assets are held separately from the insurer’s other assets, which protects investors in the event of the firm’s insolvency.
Segregated funds provide exposure to rising markets but typically guarantee to return a minimum portion of the investor’s capital after 10 years—usually 75 percent or 100 percent—even if the market has tanked. Guarantees also kick in at death, and the assets are usually beyond the reach of creditors should a business owner get sued or go bankrupt.
All these guarantees come with costs, which is why not everyone is a fan of seg funds. “At the end of the day you’re buying an insurance policy,” says Jason Heath, certified financial planner with E.E.S. Financial Services Ltd. in Markham, Ontario. Investors can accomplish the same thing at lower cost by having a conservative allocation of stocks and fixed-income investments, and by structuring their business affairs to keep personal assets away from creditors, he says.
As the name implies, closed-end funds issue a set number of shares and typically don’t sell new units or redeem existing ones. If you want to invest in a closed-end fund after its initial public offering, you have to buy shares on a stock exchange from someone who is selling.
This means the price is determined by supply and demand, unlike mutual funds and ETFs, which trade based on the underlying net asset value of the fund. Closed-end funds can trade at a premium or, more commonly, a discount to NAV.
While investors can come out ahead by buying closed-end funds that are trading at a hefty discount, you also have to watch out for risks, says Gail Bebee, author of No Hype: The Straight Goods on Investing Your Money. Some funds are thinly traded and can’t be easily bought and sold, and managers sometimes use leverage and exotic trading strategies, which can magnify gains—and losses.
Hedge funds can go long, go short (bet that a stock will fall), use borrowed money, derivatives, and just about any other speculative tool at their disposal. They’re less transparent than mutual funds, aren’t subject to the same regulation, and their compensation structure is also different.
Typically, a fund will charge a management fee of about 2 percent plus a performance fee of 20 percent of any profits above a certain threshold. (And no, the fund doesn’t pay you when it loses your money).
While some hedge funds, true to their name, hedge their positions to minimize risk, others are highly speculative. Remember all the hedge funds that blew up during the financial crisis? “Part of the problem with performance bonuses is that it motivates the manager to take extra risk,” says Garth Rustand, executive director of the Vancouver-based Investors-Aid Co-operative of Canada, which provides fee-only services and information to investors. “There’s still a perception out there that big risk will get you big gains. Well, it doesn’t happen.”
Learning about the various types of funds can make you a more informed investor, but there’s really no need to pay a lot of fees or make things too complex, he says. Most people can do just fine owning a small number of low-cost mutual funds or index ETFs, and giving the more exotic fund classes a pass.
Value of Canadian mutual fund assets: $720-billion
Value of Canadian-listed exchange-traded funds: $36.2-billion
Value of segregated fund assets in Canada: $83.3-billion
Value of hedge fund assets in Canada: $45.7-billion
Value of closed-end funds: $24.1-billion
Source: Investor Economics