Funds Articles

Cheat Sheet / Updated 02-24-2022

When I invest my own money, I've long used the best mutual funds. To make the most of your money when investing in funds, you should be sure that you have your overall finances in order. You should also understand what works and doesn’t work and what will maximize your chances for success and minimize your chances of problems in funds. The following will guide you well in your journey.

Article / Updated 12-22-2021

In the investment world, "I run a hedge fund" has the same meaning as "I'm a consultant" in the rest of the business world. In general, a hedge fund is a private partnership that operates with little to no regulation from the U.S. Securities and Exchange Commission (SEC). A hedge fund uses a range of investment techniques and invests in a wide array of assets to generate a higher return for a given level of risk than what's expected of normal investments. In many cases, hedge funds are managed to generate a consistent level of return, regardless of what the market does. To understand what a hedge fund is, it helps to know what hedging is. Hedging means reducing risk, which is what many hedge funds are designed to do. Although risk is usually a function of return (the higher the risk, the higher the return), a hedge fund manager has ways to reduce risk without cutting into investment income. A hedge fund manager can look for ways to get rid of some risks while taking on others with an expected good return. For example, a fund manager can take stock market risk out of the fund's portfolio by selling stock index futures. Or (s)he can increase her return from a relatively low-risk investment by borrowing money, known as leveraging. Keep in mind, however, that risk remains, no matter the hedge fund strategy. The challenge for the hedge fund manager is to eliminate some risk while gaining return on investments — not a simple task, which is why hedge fund managers get paid handsomely if they succeed. Characteristics of hedge funds A hedge fund differs from so-called “real money” — traditional investment accounts like mutual funds, pensions, and endowments — because it has more freedom to pursue different investment strategies. In some cases, these unique strategies can lead to huge gains while the traditional market measures languish. The amount of potential return makes hedge funds more than worthwhile in the minds of many accredited and qualified investors. Here, are some of the basic characteristics of hedge funds. Hedge funds are illiquid One key characteristic of hedge funds is that they’re illiquid. Most hedge fund managers limit how often investors can take their money out; a fund may lock in investors for two years or more. In other words, investing in a hedge fund is a long-term proposition because the money you invest may be locked up for years. Hedge funds have little to no regulatory oversight Hedge funds don’t have to register with the U.S. Securities and Exchange Commission (SEC). Most funds and their managers also aren’t required to register with the Financial Industry Regulatory Authority or the Commodity Futures Trading Commission, the major self-regulatory bodies in the investment business. However, many funds register with these bodies anyway, choosing to give investors peace of mind and many protections otherwise not afforded to them (not including protection from losing money, of course). Whether registered or not, hedge funds can’t commit fraud, engage in insider trading, or otherwise violate the laws of the land. Hedges use aggressive investment strategies In order to post a higher return for a given level of risk than otherwise expected, a hedge fund manager does things differently than a traditional money manager. This fact is where a hedge fund’s relative lack of regulatory oversight becomes important: A hedge fund manager has a broad array of investment techniques at his disposal that aren’t feasible for a tightly regulated investor, such as short selling and leveraging. Managers receive bonuses for fund performance Another factor that distinguishes a hedge fund from a mutual fund, individual account, or other type of investment portfolio is the fund manager’s compensation in the form of a performance fee. (SEC regulations forbid mutual funds, for example, from charging performance fees.) Many hedge funds are structured under the so-called 2 and 20 arrangement, meaning that the fund manager receives an annual fee equal to 2 percent of the assets in the fund and an additional bonus equal to 20 percent of the year’s profits. You may find that the percentages differ from the 2 and 20 formula when you start investigating prospective funds, but the management fee plus bonus structure rarely changes. Hedge funds use biased performance data What gets investors excited about hedge funds is that the funds seem to have fabulous performances at every turn, no matter what the market does. But the great numbers you see in the papers can be misleading because hedge fund managers don’t have to report performance numbers to anyone other than their fund investors. Those that do report their numbers to different analytical, consulting, and index firms do so voluntarily, and they’re often the ones most likely to have good performance numbers to report. Add to that the fact that hedge fund managers can easily close shop when things aren’t going well; after it shuts down it doesn’t report its data anymore (if it ever did), and poorly performing funds are most likely to close. What all this means is that measures of hedge fund performance have a bias toward good numbers. Hedges are secretive about performance and strategies Some hedge funds are very secretive, and for good reason: If other players in the market know how a fund is making its money, they’ll try to use the same techniques, and the unique opportunity for the front-running hedge fund may disappear. Hedge funds aren’t required to report their performance, disclose their holdings, or take questions from shareholders.

Cheat Sheet / Updated 10-01-2021

An exchange-traded fund (ETF) is something of a cross between an index mutual fund and a stock. It’s like a mutual fund but has some key differences you’ll want to be sure you understand. Here, you discover how to get some ETFs into your portfolio, how to choose smart ETFs, and how ETFs differ from mutual funds.

Article / Updated 03-26-2016

Hedge funds are designed to reduce an investment risk (called hedging) while maintaining a good return on investment. You can sort hedge funds into two basic categories: absolute-return funds and directional funds. The following sections look at the differences between the two. Hedge funds are small, private partnerships, and hedge fund managers can use a wide range of strategies to meet their risk and return goals. For these reasons, we can't recommend any funds or fund families to you, and we can't tell you that any one strategy will be appropriate for any one type of investment. That's the downside of being a sophisticated, accredited investor: You have to do a lot of work on your own! Absolute-return funds Sometimes called a "non-directional fund," an absolute-return fund is designed to generate a steady return no matter what the market is doing. An absolute-return fund has another moniker: a pure-alpha fund. In theory, the fund manager tries to remove all market risk in order to create a fund that doesn't vary with market performance. If the manager removes all the market risk, the fund's performance comes entirely from the manager's skill, which in academic terms is called alpha. An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. Some people say that absolute-return funds generate a bond-like return because, like bonds, absolute-return funds have relatively steady but relatively low returns. The return target on an absolute-return fund is usually higher than the long-term rate of return on bonds, though. A typical absolute-return fund target is 8 to 10 percent, which is above the long-term rate of return on bonds and below the long-term rate of return on stocks. Directional funds Directional funds are hedge funds that don't hedge — at least not fully. Managers of directional funds maintain some exposure to the market, but they try to get higher-than-expected returns for the amount of risk that they take. Because directional funds maintain some exposure to the stock market, they're sometimes called beta funds and are said to have a stock-like return. A fund's returns may not be steady from year to year, but they're likely to be higher over the long run than the returns on an absolute-return fund. A directional fund's return may be disproportionately larger than its risk, but the risk is still there. These funds can also swing wildly, giving a big return some years and plummeting big in others. Longer-term investors may not mind as long as the upward trend is positive.

Article / Updated 03-26-2016

Hedge funds are expensive, for a variety of reasons. If a fund manager figures out a way to get an increased return for a given level of risk, he deserves to be paid for the value he creates. One reason hedge funds have become so popular is that money managers want to keep the money that they earn instead of getting bonuses only after they meet big corporate overhead. Face it — a good trader would rather keep his gains than share them with an overpaid CEO who doesn’t know a teenie from a tick. Almost all hedge fund managers receive two types of fees: management fees and performance fees. More than anything else, this business model, not the investment style, distinguishes hedge funds from other types of investments. A management fee is a fee that the fund manager receives each year for running the money in the fund. Usually set at 1 percent to 2 percent of assets in a fund, the management fee covers certain operating expenses, salaries for the fund manager and staff, and other costs of doing business. The fund pays other expenses in addition to the management fee, such as trading commissions and interest. For example, say a hedge fund has $100,000,000 in assets. It charges a 2-percent management fee, which is $2,000,000. The fund has an additional $1,750,000 in trading expenses and interest. The fund investors have to pay fees from the assets whether the fund makes money or bombs. Most hedge funds take a percentage of the profits as a performance fee — also called the incentive fee or sometimes the carry. The industry standard is 20 percent, although some funds take a bigger cut and some take less. You need to read the offering documents you receive from a fund to find out what the fund charges and whether the fund’s potential performance justifies the fee. If the fund loses money, the fund manager gets no performance fee. In most funds, the fund managers can’t collect performance fees after losing years until the funds’ assets return to their previous high levels, sometimes called the high-water marks.

Article / Updated 03-26-2016

The Standard & Poor’s 500 (S&P 500) tracks the 500 largest (measured by market value) publicly traded companies. The publishing firm Standard & Poor’s created this index. Because it contains 500 companies, the S&P 500 represents overall market performance better than the Dow Jones Industrial Average’s (DJIA) 30 companies. Money managers and financial advisors actually watch the S&P 500 stock index more closely than the DJIA. Most mutual funds especially like to measure their performance against the S&P 500 rather than against any other index. Mutual funds that concentrate on small-cap stocks usually prefer an index that has more small-cap stocks in it, such as the Russell 2000. The S&P 500 doesn’t attempt to cover the 500 “biggest” companies. Instead, it includes companies that are widely held and widely followed. The companies are also leaders in a variety of industries, including energy, technology, healthcare, and finance. The index is market-value weighted. Although it’s a reliable indicator of the market’s overall status, the S&P 500 also has some limitations. Despite the fact that it tracks 500 companies, the top 50 companies encompass 50 percent of the index’s market value. This situation can be a drawback because those 50 companies have a greater influence on the S&P 500 index’s price movement than any other segment of companies. In other words, 10 percent of the companies have an equal impact to 90 percent of the companies on the same index. Therefore, although the index better represents the market than the DJIA, the index may not offer an accurate representation of the general market. S&P doesn’t set the 500 companies they track in stone. S&P can add or remove companies when market conditions change. They can remove a company if it isn’t doing well or goes bankrupt, and they can replace a company in the index with another company that is doing better.

Article / Updated 03-26-2016

Most hedge funds are structured as lightly (if at all) regulated investment partnerships, but that doesn’t mean that the partners within a fund are equal. Some partners stand on higher ground than others, and the structure of the fund affects the liability that investors may take on. If you buy into a hedge fund, you enter into a partnership, and you need to know what rights and obligations you have — especially if something goes wrong. A hedge fund’s general partners are the founders and money managers of the fund. These people have the following responsibilities: Form the fund Control the fund’s investment strategy Collect the fees charged Pay the bills Distribute the bonuses In exchange for their control, general partners take on unlimited liability in the fund, which means that their personal assets are at stake if the fund’s liabilities exceed its assets. Many general partners own their stakes through S corporations (an ownership structure for small businesses that under U.S. tax code provides owners with limited liability and tax advantages) or other structures that shield their personal assets. The limited partners (often shortened to limiteds) of a hedge fund are the people who invest in the fund — yep, you. When investors give their money to the fund manager (a general partner) to invest, they take a stake in the fund as a business. Limited partners can come in many different flavors: Individual investors, pension funds, or endowments Brokerage firms or investment companies that are sponsoring the fund’s general partners Other partnerships or corporations formed to make investments in hedge funds Limited partnership has its drawbacks. Limited partners pay fees to the general partners for their management services. They have little or no say in the fund’s operations. And the fund may restrict ongoing communication with the general partners to only a few times per year. But in exchange for these limitations of control, limited partners have limited liability. You can lose only the amount you invest in the fund and no more. If the hedge fund goes belly-up and a landlord comes looking for back rent, he can go after the general partners and their personal assets, but he can’t come to the limited partners and ask them for money.

Article / Updated 03-26-2016

You can sort hedge funds into two basic categories: absolute-return funds and directional funds. The hedge fund that you choose depends on your investment strategy. Absolute-return hedge funds as investments Sometimes called a “non-directional fund,” an absolute-return fund is designed to generate a steady return no matter what the market is doing. Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady. In truth, the label is just a matter of personal preference. An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. Hedge fund managers can use many different investment tools within an absolute-return strategy. Investing in directional hedge funds Directional funds are hedge funds that don’t hedge — at least not fully. Managers of directional funds maintain some exposure to the market, but they try to get higher-than-expected returns for the amount of risk that they take. Because directional funds maintain some exposure to the stock market, they’re said to have a stock-like return. A fund’s returns may not be steady from year to year, but they’re likely to be higher over the long run than the returns on an absolute-return fund. Directional funds are the glamorous funds that grab headlines for posting double or triple returns compared to those of the stock market. The fund managers may not do much hedging, but they have the numbers that get potential investors excited about hedge funds. A directional strategy is most appropriate for aggressive investors willing to take some risk in exchange for potentially higher returns.

Article / Updated 03-26-2016

With about 1,300 exchange-traded funds available, where do you start to shop? The answer depends on your objective. If you are looking to round out an existing portfolio of stocks or mutual funds, your ETFs should complement your existing investments. Your goal is always to have a well-diversified collection of investments. If you are starting to build a portfolio, you want to make sure to include stocks and bonds and to diversify within those two broad asset classes. There is not much in the world of stocks, bonds, and commodities that can’t be satisfied with ETFs. Keep the following guidelines in mind as you make selections: Mix and match your holdings appropriately. You not only want a well-diversified portfolio, but you also want one that includes various asset classes that tend to go up and down in value at different times. There’s no point to holding four different ETFs that all invest in large cap stocks. Hold a large cap ETF and a small cap, a U.S. stock ETF and an international stock ETF. Go for lowest cost. As with any other investment vehicle, be careful of paying more than you need to. Although most ETFs are very economical, some are more economical than others. You may not always want to pick the cheapest, but certainly aim in that direction. Don’t sweat the small stuff. Two ETFs that track similar indexes (such as, say, large value stocks) are not going to be all that different from one another. Spend some time researching your options, but don’t agonize over your selection. Much more important — perhaps worth a little agony — is choosing ETFs that track dissimilar indexes so your eggs are in different baskets. Go passive. A handful of ETFs promise “active management.” Know that active management has an awfully spotty track record. The bulk, if not all, of your ETF portfolio should be in passively managed (indexed) ETFs. Look for breadth. Examine the holdings of the ETF. As a rule, no one security (such as, for example, Microsoft or General Electric stock) should represent more than 10 percent of the ETF’s total assets.

Article / Updated 03-26-2016

At first glance, an exchange-traded fund (ETF) may seem awfully similar to a mutual fund. After all, like ETFs, mutual funds also represent baskets of stocks or bonds. The two, however, are certainly not twins. Maybe not even siblings. Cousins are more like it. Here are some of the significant differences between ETFs and mutual funds: ETFs are bought and sold just like stocks (through a brokerage house, either by phone or online), and their price can change from second to second. Mutual fund orders can be made during the day, but the actual trade doesn’t occur until after the markets close. ETFs tend to represent indexes — entire markets or market segments — and the managers of the ETFs tend to do very little trading of securities in the ETF. (The ETFs are passively managed.) Although they require you to pay small trading fees, ETFs usually wind up costing you much less than a mutual fund because the ongoing management fees are typically much less, and there is never a load (an entrance or exit fee, sometimes an exorbitant one) as there is with some mutual funds. Because of low portfolio turnover and also the way they are structured, investment gains on ETFs usually are taxed more gingerly than the gains on mutual funds. The following table provides a quick look at some ways that investing in ETFs differs from investing in mutual funds. ETFs Mutual Funds Priced, bought, and sold throughout the day? Yes No Offer some investment diversification? Yes Yes Is there a minimum investment? No Yes Purchased through a broker or online brokerage? Yes Yes Do you pay a fee or commission to make a trade? Often Sometimes Can you buy/sell options? Yes No Indexed (passively managed)? Typically Atypically Can you make money or lose money? Yes Yes