Mutual Funds: Hedge and Exchanged-Traded Funds

There are numerous kinds of mutual funds that allow investors to receive a secure rate of return with minimal risk.  While the funds have various amounts of risk, it still behooves investors to research each kind of fund and be fully cognizant of the investment they are making.

Open-End Mutual Fund
An open-ended mutual fund issues new shares to investors and buy back shares when investors wish to sell.  These funds do not have restrictions on the amount of shares the fund will issue.  If demand is high enough, the fund will continue to issue shares no matter how many investors there are.  In such funds, when the investment manager determines the total assets are too large to execute its stated objective, the fund will be closed to new investors.  In some extreme cases, it may be closed to new investment by existing fund investors.

Closed Mutual Fund
As referred to above, closed funds are closed either temporarily or permanently to new investors after an investment manager is concerned the asset base is too large to execute his investing style.  Shareholders in a closed mutual fund are allowed to continue investing in that fund, yet they are often precluding from other investments.

These funds differ from closed-end funds.  Despite the similar name, the latter is structured and listed as a stock on a stock exchange.  Closed-end funds have a fixed number of shares and generally invest in technical or other specialized sectors.

Equity Funds
Equity funds are the most common kind of mutual fund; in fact, they hold 50% of all mutual fund investments in the United States.  Equity funds tend to invest in equity as opposed to investments in stock and bond funds.

Bond Funds
Accounting for 18% of mutual fund assets, bond funds presently include term funds, municipal bonds, and high -yield bonds.  Term bond funds have a fixed set of time prior to maturity.  Municipal bond funds have numerous tax advantages and lower risk but at the expense of having lower rates.  High-yield bonds tend to invest in corporate bonds and while there is much potential for a large return, there is also significant risk.

There is presently a misconception that bond funds have little to no risk.  However, this is a falsehood as bond funds are subject to numerous risks i.e. prepayment risks, interest risks, and credit risks.  An investor is responsible for reading all of the fund’s information, and the information can be retrieved from the prospectus, which discloses most risks.

Money Market Funds
Holding 26% mutual fund assets in the United States, Money market funds are a conservative approach to investing with mutual funds.  They receive some of the lower rates of return, though entail the least amount of risk as well.  These funds pay dividends that generally reflect short-term interest rates.  Such typically invest in certificates of deposit, commercial paper of companies, government securities, or other highly liquid securities.  Despite the low amount of risk, it is still important that an investor reads all of the fund’s available information, including its prospectus and most recent shareholder report.

Low Risk Mutual Funds

There are several mutual funds that, should the investor conduct research, can bring respectable rates of return without too much risk.

Exchange-Traded Mutual Funds

The exchange-traded fund is similarly structured to an open-end investment company.  They are traded on the stock exchange, and most are index funds and stock market indexes.  Exchange-traded funds are more efficient than traditional mutual funds and thus have fewer expenses.  Exchange-traded funds provide low expense ratios and tax efficiency of index funds.

Exchange-traded funds have numerous advantages.  First, they generally have lower costs because they are not actively managed and are insulated from the costs associated with buying and selling securities.  Next, these funds can be bought at current market prices at any time during the day, unlike traditional mutual funds that can only be traded at the day’s end.  Third, exchange-traded funds generate low capital gains, thus there is enhanced tax efficiency.  Fourth, these funds provide diversification across entire indexes.  Finally, exchange-traded funds have transparent portfolios that are frequently priced during the trading day.
There are various kinds of exchange-traded funds.  Index funds hold securities and try to copy the performance of a stock market index.  Commodity exchange-traded funds include commodities such as metals and fixtures and they are generally index fund that do not invest in securities.  Exchange traded commodities are asset-backed bonds that track the performances of underlying commodity indexes.  Bond exchange traded funds invest in U.S. Government bonds and do well during recessions as investors put their money into U.S. Treasuries.  There are numerous other kind of exchange-traded funds: currency exchange-traded funds, actively-managed funds, hedge fund exchange-traded funds, exchange-traded grantor trusts.  Shareholders should research these before making an investment.

Hedge Funds

Hedge funds are speculative funds that make large bets on market movements. These funds are open to certain investors who are permitted by regulators to undertake a wider range of investment.  Unlike mutual funds, hedge funds have loose SEC regulations, though some managers are forced to register with the SEC as investment advisers.
There are well over 8000 hedge funds, which partake in a $1 trillion industry.  Most hedge funds are highly specialized, and many successful managers limit the amount of capital they will accept due to the fact that many strategies are limited to how much capital the managers can employ before the returns diminish.  Most hedge fund strategies seek to reduce market risk through derivatives or shorting equities.  Because the potential for substantial profit is so great, more and more pension funds and endowments allocate assets to hedge funds.  Additionally, private banks tend to favor these kinds of investments, as they, in particular the old ones, understand the consequence of major stock market corrections.

In part due to the recession of 2009, there is a present misconception that all hedge funds are volatile.  Some believe that all hedge funds use global macro strategies and place large directional bets on bonds, gold, and other commodities, while using lots of leverage.  In fact, only 4%-5% of all hedge funds are global macro funds and most use derivates only for hedging, if at all, without using any leverage.