It’s important to understand the variety of options available when it comes to funds for investment. This article will break down the various options, highlighting their pros and cons.
What Is a Fund?
A fund is a pool of money that is managed by a professional. The professional is responsible for finding investments that suit the funds’ objective. The profits from the investments are shared among those who have contributed to the pool of money. The professional fund manager is then compensated with a share of the money for his or her time and efforts.
The advantages of funds are:
- Individuals don’t have to worry about the various intricacies of investing. The finer details and executions are handled by the fund managers while you can focus on the broad level direction of your portfolio.
- They are quite efficient. For instance, if you want to have a diverse range of investments, you will pay a lot in trading fees for buying and selling each stock. The fund manager, however, can do this in “wholesale” and get cheaper rates. (Read more about collective investment scheme.)
One of the most popular types of funds are mutual funds. Investors typically invest in stocks that the fund manager thinks are appropriate for the risk level of the fund.
Some of the biggest problems with mutual funds are:
- Mutual funds require a dedicated manager, which can get pretty expensive. These managers get upwards of $200,000 per year as salary. In general, a mutual fund charges 1-2 percent of your investment as a yearly fee. Thus, if your investment makes 9 percent, you might get only 7 percent after the fee. This 2 percent difference can be huge. If you are investing $1,000 for your retirement, the fund would go to $13,000 with a 9 percent return and just $7,000 with a 7 percent return. That’s a $6,000 difference.
- Given its inefficiency, many mutual funds require a minimum $10,000 investment, thus pricing out many investors.
- With mutual funds, you can trade in the middle of the day.
Evolution of ETFs
By the 1980s, finance researchers found that many of these dedicated fund managers perform no better than someone who blindly picks all the major stocks in a market. Technology also enables people to automate many of the processes. Thus, in 1993, a new invention was made.
With ETFs, the fund managers don’t have much of a job. What they do is pick a certain group of stocks called an index. The biggest advantage of an index is that you no longer need to pick a winner in a market. For instance, if you split your money between Apple, Google and Microsoft stocks, you will likely win no matter which company wins the tech battle for computers and mobile devices.
Suppose you want to start a fund that focuses on cloud computing. What you should do is pick a list of companies related to cloud computing. Select 10 stocks and assign them almost equal weights. That means for every $100 in the fund, you would invest $3 in Rackspace stocks, $3 in Akamai and so on.
- Rackspace Hosting, Inc. (RAX): 3.31%
- F5 Networks, Inc. (FFIV): 3.29%
- Brightcove, Inc. (BCOV): 3.29%
- TIBCO Software, Inc. (TIBX): 3.28%
- Red Hat, Inc. (RHT): 3.23%
- Akamai Technologies, Inc. (AKAM): 3.22%
- NetSuite, Inc. (N): 3.20%
- Oracle Corporation (ORCL): 3.20%
- Teradata Corporation (TDC): 3.19%
- Equinix, Inc. (EQIX): 3.18%
Then, after you set up an automated trading process, as soon as someone puts money in your fund, your software automatically buys these stocks in the indicated ratio. Now, you can buy and sell in that fund all day long without worrying about paying fund managers. (The example above is taken from a real ETF named SKYY.)
Now, you can start getting creative. How about starting a gold ETF? In this ETF, instead of buying stocks, you can buy gold bars. Thus, as soon as someone puts $1,000 in the fund, you can place an order for $1,000 worth of gold bars and store it in a vault. The same can be done for almost any asset.
- Funds help investors manage their investments without getting lost in the details.
- ETFs are types of funds that almost does away with a professional fund manager and replaces it with an automated technology.
- ETFs are extremely efficient given the low overheads.