You are probably aware that in your retirement portfolio, you need to diversify your risks by owning different types of assets. Unless you are one of the few people whose career is in finance, you may not feel that you want to dedicate the time and energy needed to research dozens of different investments. There are several kinds of advisors who are happy to take your money and invest it for you, in exchange for handsome (not to say ridiculously high) fees.
But, if you want to be at least somewhat hands-on with your investments, there are a few different kinds of so-called pooled investments that are available to you. By selecting a handful of these, you can get the benefits of diversification and avoid many of the fees. In this article, we’ll do a brief rundown of the most common types and go into more detail on one of them. In future articles, we’ll more fully describe the other types.
What Are Pooled Investments?
The basic idea of any pooled investment is that the investors own shares in a fund, which in turn owns a portfolio of investment assets. The investors’ returns consist of distributions of cash or other property paid out by the fund; as well as changes in the value of the funds’ shares. Exactly how this is accomplished differs from one type of pooled asset to another. The potential benefits of any pooled investment are diversification, savings due to scale, and, for actively-managed funds, professional management.
Some of the main categories of publicly-available pooled investments are:
- Mutual Funds (also called open-end funds)
- Collective Investment Trusts (CITs)
- Exchange-traded funds (ETFs)
- Closed-end Funds (CEFs)
To some extent, your choice of fund type may be dictated by the environment in which you are investing. Inside of a 401(k) or other similar employer-sponsored pension plan, you may be offered only CITs, or only mutual funds. In that case, the best that you can do is choose the best from among the ones offered to you. How to make that selection is an article in itself, that we’ll go into at another time.
What Are Differences in Pooled Investment Types?
If you are not constrained by someone else’s rules, you can consider all types. Here’s how they are the same, and how they are different:
Each of the fund types is a pool of capital that is run by a manager or management team. The investors in the fund indirectly own the assets that are in the pool. The investors may receive cash distributions from the pool derived from dividends, interest, rents or royalties generated by the assets in the pool. The investors may also benefit from increases in value of the assets themselves, reflected in the price of the pool units or shares. The management pays itself by taking money out of the pool. The rate at which they pay themselves is called the fund’s expense ratio. It can range from a few basis points (a basis point is 1/100 of 1% of the total value of the fund) to 2 full percentage points (200 basis points) every year, or even more. The level of fees charged has a big impact on the investor’s net return.
How Do Open-ended Mutual Funds Work?
The pooled investment type that is most familiar is the open-ended mutual fund. In this case, open-ended means that new shares can be created on demand and sold by the fund company to investors. The fund purchases more assets with any new money that is put into the fund. When investors want to sell their fund shares, the fund buys them back or redeems them. The price paid upon redemption is equal to the Net Asset Value per share (NAV) of the fund at the time of redemption. When redemptions exceed new money, the fund must sell assets to raise the cash to pay off the redeemed units.
Open-ended funds have two main subtypes: actively-managed funds and passively-managed funds. In the actively-managed subtype, the management attempts to use superior asset selection skills to do better than the benchmark for the asset type used. This is where the vaunted professional management comes in. The management will buy and sell assets with the pool money at its discretion to try to achieve their investment goals. There is often significant turnover within the fund, which generates short- and long-term capital gains or losses as well as generating trading costs.
The second sub-type is passively-managed mutual funds. These are mainly index funds. Such a fund owns the assets that are listed as part of a specific index, such as the Standard & Poor’s 500, the Russell 2000 Small-cap index, the Aggregate Bond Index, etc. The management of this type of fund has no investment decisions to make. They simply invest in the assets that are part of the index, in the same proportions as in the index. Whenever the indexes are rebalanced, the fund management sells the assets that have been removed from the index and buys those assets that have been added to the index; and rebalances the fund. This is a clerical exercise not requiring the skills of a high-powered stock picker, so the expense ratio for passively managed funds is generally much lower than for actively managed funds.
Beating the indexes is not easy. The indexing process itself winnows out losers (because they cease to meet the requirements to be included in the index) and replaces them with up-and-coming winners. Most actively managed funds do not beat their index benchmarks consistently, and the actively-managed funds incur more trading costs as well.
For all mutual funds, active and passive, the realized capital gains and losses within the fund are taxable to the mutual fund investors, who receive a 1099 each year. The 1099 also reports any distributions the investors received from the fund and characterizes the distribution as qualified (special tax treatment), non-qualified (taxed at ordinary income rates), capital gain (taxed at capital gains rates) or return of capital (not taxed).
Mutual funds are regulated by the SEC. They have extensive reporting requirements. There is a great deal of publicly available information on the fund’s holdings and performance. Morningstar is a good source for this information.
Mutual funds are mainly useful when they are your only choice, i.e. within an employer’s pension plan.
How Does a Collective Investment Trust Work?
That statement also applies to the next pool type, the Collective Investment Trust or CIT.
Collective Investment Trusts are similar to mutual funds, except that they are not publicly available; they are sort of private-label funds usually offered exclusively to employees in a pension plan. CITs have very minimal reporting and compliance requirements compared to mutual funds. This can be both good and bad. The good is that their fees tend to be lower. The bad is that there is no neutral information available about them. The only available information comes from the fund itself.
In any situation where you are not constrained in your selection by your employer’s offerings, you will also want to consider the other types of pooled investments, the Exchange-traded Funds and the Closed-end Funds. More about them in the next installment.