Personal Finance 101: What Are Funds?

This was originally posted on Planner Bee.

An investment fund is the pooled capital from various investors and is placed into a diversified basket of investment assets such as stocks, REITs, bonds and short-term debts.

Funds are managed by a team of financial professionals who make investment decisions on the investors’ behalf. They aim to increase the overall value of the assets in the funds to generate profits for their investors. Funds provide investors with portfolio diversification, professional management, and potential for capital appreciation.

Some benefits of investing in funds:

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

Some drawbacks 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
• 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 these funds hold include U.S. Treasury certificates of deposit and commercial paper.

Read more: All You Need To Know About Treasury Bills

These funds are considered one of the safest investments but naturally provide investors with very minimal growth. The returns usually do not keep up with the rate of inflation but their entry cost is low with relatively low fees. These funds aim to provide investors with a high degree of liquidity and capital preservation, but just a modest level of returns.

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 funds or hybrid funds)

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 regularly, which is then paid to investors as a form of dividend.

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, which are found 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.

These funds provide investors with a steady income stream, capital preservation, and lower volatility compared to equity funds. They are a popular choice for conservative investors, retirees, or those looking to diversify their investment portfolio with lower-risk assets.

Mixed asset funds (hybrid funds)

Mixed asset funds are also known as hybrid funds or balanced funds. These funds invest in different asset classes, typically stocks (equities) and bonds (fixed income), within a single portfolio.

Mixed asset funds aim to provide a balance between growth and income, offering diversification benefits and potentially reducing risk through a varied investment approach.

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 funds)

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, securities, or stocks to create a desired fixed ratio, these funds invest in a portfolio of other mutual funds or hedge funds.

The cost of managing for fund of funds tends to be higher than standalone mutual funds.

The risks of such funds depend 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.

Fund of funds offer investors a convenient way to gain diversified exposure across various asset classes and investment strategies through a single investment.

Equity funds (stock funds)

Equity funds, also known as stock funds, are mutual funds that primarily invest in stocks or shares of companies. Managed by professional fund managers who select and manage the portfolio to achieve specific investment objectives, these funds can invest in as many as 100 different companies within an equity fund at a time.

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.

Equity funds provide investors with an opportunity to participate in the potential growth and profits of publicly traded companies.

REITs (stock funds)

Real Estate Investment Trusts (REITs) are investment vehicles that own, operate, and/or finance income-generating real estate across various property sectors.

There are various types of REITs including retail, commercial, office, residential, hospitality, and healthcare REITs. There is also diversified REIT where the company owns and manages a diversified portfolio of commercial real estate.

Through REIT investing, you receive dividends paid to you from the rental income and/or profits arising from the management of the real estate. REITs provide investors with an opportunity to invest in a diversified portfolio of real estate assets, offering both income and potential capital appreciation, at a low entry cost as investors do not need to purchase a property for investment.

REITs can be traded like stocks throughout the day, making it a very flexible form of investment, suitable for investors who look for liquidity in their investments.

REITs are also easily confused with real estate funds; the former is usually a corporation that invests in income-producing real estate and pays out dividends, while the latter is a mutual fund that invests in securities offered by public real estate companies and provides value through appreciation.

ETFs (could be bond or equity funds)

Exchange Traded Funds (ETFs) are also commonly known as index funds. They are designed to track the performance of a specific index, sector, commodity, or asset class. 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, this person 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 requires 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. ETFs trade intraday, just like stocks. ETFs provide investors with a convenient and cost-effective way to gain diversified exposure to various markets and asset classes, and are highly liquidable investments.

Index mutual funds (any of the four funds)

An index mutual fund aims to track the performance of a particular market index, such as the S&P 500 and the Straits Times index.

Unlike actively managed funds, index mutual funds are passively managed. The fund manager’s goal is to mirror the performance of the index rather than trying to outperform it. As such, the costs involved in an index mutual fund are lower than that of an actively managed fund.

Index funds typically match the performance of the index they track, which historically has provided competitive returns over the long term. These funds aim to provide their investors with broad market exposure, low operating expenses, and low portfolio turnover.

Read more: The Great Debate: Active vs Passive Investment

Specialty funds (hybrid funds)

Specialty funds include hedge funds, managed futures, commodities and real estate funds as well as increasingly popular socially responsible funds. Specialty funds invest primarily in companies within a particular sector or that follow a particular theme, such as sustainability, technology, and healthcare.

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, and child labour. That makes for a way to play a part in making a positive difference in the world while investing.

Of course, the risks involved would be quite different from regular funds, as speciality 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.

Specialty funds can be a valuable component for an investor who wants to have a diversified investment strategy, especially for those with a strong belief in the growth potential of a particular sector or theme.

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 replace the human investment manager. The extent to which “robots” manage your funds differs 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.

What happens when a fund management firm shuts down?

Now that you know more about the various funds out there, you may question: what happens when a fund management firm shuts down?

There are two likely scenarios:

1. The trustees of the fund will sell the underlying assets and return net asset value to the investors
2. 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.

In the second option, your fund will either continue as planned, or you will be given the option to participate in the new investment direction.

With a better understanding of various funds, you are better equipped to make investment decisions should you decide to explore this path. It is always prudent to ask yourself what your aims are, as well as think about your risk appetite and capital to decide which routes are best suited for you.