Personal Finance 101: What are “Funds”?

Funds are a type of investment tool that pools money from various people, and is placed into a diversified basket of investment assets such as Stocks, REITs, Bonds and Short-term Debts.

The fund is managed by a team of financial professionals who generate a regular income in the form of dividends or a profit as the assets in the funds increase in overall value.

Benefits of investing in funds:

• Low cost (compared to other forms of investments such as property)
• Low minimum capital requirements
• Diversified investments with a budget
• Highly liquid (you can typically sell your investments within 3 days)
• Lower risk compared to buying single company shares

Cons of investing in funds:

• Opportunity cost is always a consideration. If you have other forms of investments that could earn you a higher rate of return with similar risks, then funds may not be the best option for you
• There are management fees and expenses to be paid in exchange for the fund management services
• Some funds may not always perform better than their intended benchmark
• Returns may not be as high as a single company share

There are mainly four types of funds — money market funds, bond funds, stock funds, and hybrid funds, each with different underlying combinations of assets, risks, and rewards. Here are some common funds from the lowest to the highest risk rating.

Money market funds

Money market funds are a form of fixed-income funds. They invest in high-quality, short-term debt such as government bonds, treasury bills, bankers’ acceptances, commercial paper and certificates of deposit. Some examples of assets held by these funds include U.S. Treasury certificates of deposit and commercial paper.

These funds are considered one of the safest investments but naturally provide investors with very minimal growth. These funds are usually named “parking” funds as they are used by investors to “park” their funds while waiting for new opportunities to buy into other riskier investments.

Fixed income funds (bond fund or hybrid fund)

Fixed income funds buy investments that pay a fixed rate of return like dividend paying stocks, government bonds, investment-grade corporate bonds and high-yield corporate bonds. They aim to have money coming into the fund on a regular basis which is paid to investors as a form of dividends.

Bond funds are the most common type of fixed income funds. Instead of buying stocks, bond funds invest in government and corporate debt. Since it’s a safer investment, the rate of return is usually lower than equity funds. Bond funds, within this class, do differ in risks as well. High-yield corporate bond funds are riskier than bond funds that hold government and investment-grade bonds.

Mixed asset funds (hybrid fund)

Mixed asset funds are also known as balanced funds at times. These funds invest in a mix of equities and fixed income securities with a fixed ratio of investments such as 50% stocks and 50% bonds. This ratio varies.

For instance, aggressive funds hold more equities and fewer bonds, while conservative funds hold fewer equities relative to bonds. They try to balance the aim of achieving higher returns against the risk of losing money. Mixed asset funds tend to have more risk than fixed income funds, but less risk than pure equity funds.

Fund-of-funds (usually stock, bond, or hybrid fund)

Fund-of-funds are made up of two or more funds at a time and are a type of mixed asset fund. Instead of buying underlying investments bonds or stocks to create a desired fixed ratio, these funds invest in other funds. The cost of managing for fund-of-funds tends to be higher than stand-alone mutual funds.

The risks of such funds depends on the type of underlying asset that the fund is made up of. For instance, 100% bond funds would be lower in risk compared to a 50–50 bond and equity fund mix.

Equity funds (stock fund)

Equity funds invest in several stocks at a time, sometimes there can as many as 100 different companies within an equity fund! So instead of buying individual stocks to make up a diversified portfolio, an equity fund allows you to invest quickly at low cost and effort into many companies at a go. Equity funds typically generate higher returns compared to money market or fixed income funds, so there is usually a higher risk that you could lose money.

REITs (stock fund)

Real Estate Investment Trusts (REITs) use money to purchase and manage properties as compared to shares of a publicly listed company, where businesses use investor’s money to finance their operations.

REITs can be further broken down into retail, commercial, residential and mortgage REITs. Through REITs investing, you become a part-owner of the properties that the REIT manages, hence the rental income and profits from sales are paid to you through dividends.

REITs vs real estate funds are like ETFs vs Mutual funds. This means that REITs, like ETFs trade throughout the day, while real estate funds don’t. One important thing that you should understand is REITs invest directly in real estate and own, operate, or finance income-producing properties while Real estate funds typically invest in REITs and real estate-related stocks.

ETFs (could be bond or equity funds)

Exchange Traded Funds (ETFs) are commonly known as Index funds since most ETFs track an index. Whenever an investor buys a share of an ETF, they’re buying a portion of the underlying portfolio. An ETF is listed on the stock exchange like a stock.

If an investor wishes to participate in the performance of an index, he or she could either buy shares of each individual company listed in the index in the exact proportion determined by the index, or buy an ETF. Most people buy an ETF as it allows them to start investing with low capital and little effort to manage. The STI comprises 30 stocks while the S&P 500 index has 505 stocks.

In exchange for the hard work, and the costs involved to manage the fund, index mutual fund and ETF companies charge a small fee known as the expense ratio. Unlike the other funds (with exception to REITs) mentioned in this article that trades end of day, ETFs trade intraday, just like stocks.

Although ETFs and REITs are mentioned in this article and are commonly compared with funds, they are not actually funds.

Index mutual funds (any of the four funds)

An index mutual fund aims to track the performance of a particular market index just like an ETF, such as the S&P 500, Straits Times index. The value of the mutual fund will go up or down as the index goes up or down. Index funds typically have lower costs than actively managed mutual funds because the portfolio manager doesn’t have to do as much research or make as many investment decisions, this is commonly known as passive investing. Like equity funds, index funds can vary by company size, sector and location.

Specialty funds (hybrid fund)

Specialty funds include hedge funds, managed futures, commodities and real estate funds as well as increasingly popular socially responsible funds.

A socially responsible fund may invest in companies that support conservation and sustainable practices, human rights and diversity, and would usually avoid investing in companies involved in alcohol, tobacco, gambling, weapons, child labour. Who says you can’t make a difference in changing the world while investing?

Of course the risks involved would be quite different from regular funds, as specialty funds may often be less connected to the state of the general economy since the investment focus is a narrower scope. In many instances, returns can be higher than broad based investments like STI ETF or MSCI world, but it can come with much higher risk.

Robo funds (any of the four funds)

When you invest the traditional way, there is usually an investment manager handling your account to advise you on how to invest. Robo advisors are digital advisory services that basically replace the human investment manager. The extent to which “robots” manage your funds do differ across robo-advisers.

Some may recommend an investment portfolio based on a risk assessment algorithm, some may provide portfolio auto-rebalancing, some may even actively try to beat their benchmark through some algorithms based on the company’s knowledge of markets and investing. Fees for robo funds are usually lower than traditionally managed funds.

Now that you know the various funds out there, a question that might be on your mind is — what happens when a fund management firm shuts down?

There are two likely scenarios, the trustees of the fund will sell the underlying assets and return net asset value to the investors. Or if the firm gets acquired by another firm, the current fund may either continue its investment mandates or get merged into other schemes in the new firm.

This means that your fund will either continue as per planned, or you will be given the option to participate in the new investment direction.

Now that you understand various funds, don’t let anyone influence you to blindly invest in just any fund. Ask yourself what’s your aim, risk appetite and available sum in order to decide which funds are best suited for you!

Originally published at https://plannerbee.co on October 31, 2020.