Pooled Investments

Mutual Funds

Mutual funds are the most widely held pooled investment vehicle, providing individual investors access to professionally managed, diversified portfolios. As open-end investment companies registered under the Investment Company Act of 1940, mutual funds continuously issue and redeem shares at their Net Asset Value (NAV), calculated once daily after the market closes. Investment adviser representatives recommend mutual funds more frequently than any other investment vehicle, making thorough knowledge of their structure, fees, and performance measurement essential.

Structure and Operations

A mutual fund pools money from many investors to purchase a diversified portfolio of securities. The fund is managed by an investment adviser (management company) that makes buy and sell decisions according to the fund's stated investment objective and strategy as described in its prospectus. The fund's board of directors oversees the management company and acts in the interest of shareholders. Key service providers include the custodian (safeguards the fund's assets), the transfer agent (processes shareholder transactions and maintains records), and the distributor (sells fund shares).

Mutual funds must distribute at least 90% of their net investment income and net realized capital gains to shareholders annually to qualify as a regulated investment company (RIC) under Subchapter M of the Internal Revenue Code. This pass-through structure allows the fund to avoid paying corporate income tax on distributed earnings; instead, shareholders pay taxes on the distributions they receive.

Fee Structure

Understanding mutual fund fees is critical for advisers because fees directly reduce investor returns. The total cost of owning a mutual fund consists of several components:

• Management Fee (Advisory Fee): The fee paid to the investment adviser for managing the fund's portfolio. This is the largest ongoing expense, typically ranging from 0.10% for passive index funds to 1.50% or more for actively managed specialty funds. The management fee is expressed as a percentage of average net assets and is deducted from the fund's NAV.
• 12b-1 Fee: An annual fee charged by some funds to cover distribution and marketing costs, named after the SEC rule that permits it. The maximum 12b-1 fee is 1.00% of average net assets, with no more than 0.25% classified as a service fee. Funds charging more than 0.25% in 12b-1 fees cannot call themselves "no-load" funds.
• Expense Ratio: The total annual operating expenses of the fund expressed as a percentage of average net assets. It includes the management fee, 12b-1 fee, administrative costs, legal fees, and other operating expenses. The expense ratio is the most important cost metric for comparing funds.
• Sales Loads: Commissions charged when purchasing (front-end load, Class A shares) or selling (back-end load/contingent deferred sales charge, Class B shares) fund shares. Front-end loads reduce the amount invested; a $10,000 investment with a 5% front-end load results in only $9,500 being invested. Class C shares typically have level loads with ongoing higher 12b-1 fees but no front-end or back-end load.

Performance Measurement

Investment advisers evaluate mutual fund performance using several metrics:

• Total Return: The percentage change in NAV plus any income distributions and capital gains distributions over a specified period. This is the most comprehensive performance measure.
• Risk-Adjusted Return: Measures like the Sharpe ratio, Treynor ratio, and Jensen's alpha account for the level of risk taken to achieve returns. A fund that achieves high returns with low risk is superior to one that achieves similar returns with higher risk. These metrics are covered in Chapter 6.
• Benchmark Comparison: Returns should be compared to an appropriate benchmark index. A large-cap growth fund should be compared to a large-cap growth index (such as the Russell 1000 Growth), not to the S&P 500 or a bond index.

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) combine features of both mutual funds and individual stocks. Like mutual funds, they hold diversified portfolios of securities. Like stocks, they trade on exchanges throughout the day at market-determined prices. ETFs have grown dramatically in popularity due to their low costs, tax efficiency, and trading flexibility.

Key Differences from Mutual Funds

• Intraday Trading: ETFs trade continuously on exchanges during market hours at real-time market prices, unlike mutual funds which only trade at end-of-day NAV. This allows investors to buy and sell ETFs at any time during the trading day, use limit orders and stop orders, and even sell short.
• Lower Expense Ratios: Most ETFs are passively managed (tracking an index), resulting in lower management fees. Many broad-market ETFs charge expense ratios below 0.10%, compared to 0.50-1.50% for actively managed mutual funds.
• Tax Efficiency: ETFs use an "in-kind" creation and redemption mechanism with authorized participants that minimizes capital gains distributions. Mutual funds must sell securities when shareholders redeem, potentially generating taxable capital gains for remaining shareholders. ETFs avoid this problem because redemptions are handled through an in-kind exchange of securities rather than cash sales.
• No Sales Loads: ETFs do not charge sales loads (front-end or back-end). However, investors pay brokerage commissions when buying and selling, and there is a bid-ask spread that represents an implicit cost.
• Minimum Investment: ETFs can be purchased for the price of a single share (and many brokers now offer fractional shares), while many mutual funds require minimum investments of $1,000-$3,000 or more.

Hedge Fund Strategies

Hedge funds are private investment vehicles that pool money from wealthy individuals and institutional investors. Unlike mutual funds, hedge funds are not registered under the Investment Company Act of 1940 and face fewer regulatory restrictions. They can use leverage, short selling, derivatives, and concentrated positions that are unavailable to traditional mutual funds. Hedge funds typically charge both a management fee (often 2% of assets) and a performance fee (often 20% of profits), known as the "2 and 20" structure.

Hedge funds are offered through private placements under Regulation D of the Securities Act of 1933 and are restricted to accredited investors (generally individuals with net worth exceeding $1 million, excluding primary residence, or annual income exceeding $200,000). They are not required to provide a prospectus or register with the SEC as investment companies, though their advisers may be required to register as investment advisers.

Common Hedge Fund Strategies

• Long/Short Equity: The most common hedge fund strategy. The fund takes long positions in stocks expected to appreciate and short positions in stocks expected to decline. The net market exposure can be adjusted (net long, net short, or market neutral) based on the manager's market outlook. This strategy seeks to generate returns from stock selection (alpha) while reducing market risk (beta).
• Market Neutral: A variant of long/short equity that maintains equal dollar amounts of long and short positions, resulting in zero net market exposure (beta of approximately zero). Returns are driven entirely by the manager's ability to select winners on the long side and losers on the short side. This strategy is designed to perform regardless of market direction.
• Global Macro: Makes large directional bets on currencies, interest rates, commodities, and equity indices based on macroeconomic analysis. Global macro funds take positions across global markets and can profit from economic and political events. George Soros's Quantum Fund was the most famous global macro fund. These funds use significant leverage and can be highly volatile.
• Event-Driven: Seeks to profit from corporate events such as mergers, acquisitions, restructurings, bankruptcies, and spin-offs. Sub-strategies include merger arbitrage (buying the target and potentially shorting the acquirer in announced deals), activist investing (taking large stakes and pushing for changes), and special situations.
• Distressed Securities: Invests in the debt or equity of companies that are financially distressed, bankrupt, or emerging from bankruptcy. Distressed managers analyze the legal, financial, and operational aspects of troubled companies to identify securities trading below their recovery value. These investments are inherently illiquid and require specialized expertise.

Private Equity & Venture Capital

Private equity (PE) refers to capital invested in companies that are not publicly traded. Private equity firms raise capital from institutional investors and high-net-worth individuals through limited partnerships, then use that capital to acquire, restructure, and eventually sell companies for a profit. The general partner (GP) manages the fund and makes investment decisions, while limited partners (LPs) provide capital and have limited liability.

Private equity strategies include:

• Leveraged Buyouts (LBOs): The PE firm acquires a mature company using a significant amount of borrowed money (leverage), with the target company's assets and cash flows securing the debt. The PE firm improves operations, reduces costs, and grows revenue before selling the company (typically in 3-7 years) at a higher valuation.
• Growth Equity: Investment in mature companies that need capital for expansion, restructuring, or entering new markets. Growth equity sits between venture capital and buyouts on the risk spectrum and typically involves minority stakes rather than full acquisitions.
• Distressed PE: Acquiring companies in financial distress, bankruptcy, or restructuring at deep discounts, then implementing turnaround strategies to restore value.

Venture capital (VC) is a subset of private equity focused on investing in early-stage, high-growth-potential companies, particularly in technology, biotechnology, and other innovative sectors. VC investments are staged across rounds: seed capital (initial concept), Series A (product development), Series B (scaling), and later rounds. Venture capital is the highest-risk form of private equity, with the expectation that most investments will fail but a few will generate extraordinary returns ("home runs") that compensate for the losses.

Fund of Funds

A fund of funds invests in a diversified portfolio of other hedge funds or private equity funds rather than directly in securities. This structure provides diversification across multiple managers and strategies, which can reduce the risk of selecting a single underperforming fund. However, fund of funds charge an additional layer of management and performance fees on top of the underlying funds' fees, resulting in higher total costs. This double fee structure can significantly erode returns over time.

REITs, Commodities & Other Alternatives

Real Estate Investment Trusts (REITs)

A REIT is a company that owns, operates, or finances income-producing real estate. To qualify as a REIT and avoid corporate-level taxation, a REIT must distribute at least 90% of its taxable income to shareholders annually and derive at least 75% of its gross income from real estate-related sources. REITs provide individual investors with access to commercial real estate (office buildings, shopping centers, apartments, data centers) without the need to purchase property directly.

REITs are classified as:

• Equity REITs: Own and operate income-producing properties. Revenue comes primarily from rental income. The most common type.
• Mortgage REITs: Provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities. Revenue comes from interest on the loans. More sensitive to interest rate changes than equity REITs.
• Hybrid REITs: Combine elements of both equity and mortgage REITs.

Publicly traded REITs trade on stock exchanges and provide daily liquidity. Non-traded REITs are not listed on exchanges and have limited liquidity, often with redemption restrictions and early withdrawal penalties. Investment advisers should carefully consider liquidity needs before recommending non-traded REITs.

Commodity Pools & Managed Futures

A commodity pool is a pooled investment vehicle that trades futures contracts on commodities (agricultural products, metals, energy) and financial instruments (currencies, interest rates). Commodity pools are operated by Commodity Pool Operators (CPOs) and traded by Commodity Trading Advisers (CTAs), both regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

Managed futures strategies use systematic or discretionary approaches to trade futures and options on futures across various markets. These strategies can provide diversification benefits because their returns often have low correlation to traditional stock and bond investments. Managed futures may use trend-following, mean-reversion, or fundamental approaches.

Alternative Investment Characteristics

All alternative investments share certain common characteristics that distinguish them from traditional stocks and bonds:

• Illiquidity: Most alternatives (hedge funds, PE, VC, non-traded REITs) have limited liquidity with lock-up periods during which investors cannot redeem their money. This illiquidity premium is one source of potentially higher returns.
• Higher Risk: The use of leverage, concentrated positions, complex strategies, and illiquid assets increases the risk profile relative to traditional investments.
• Accredited Investor Requirements: Most alternatives are offered through private placements and restricted to accredited investors or qualified purchasers, limiting participation to wealthy individuals and institutions.
• Less Transparency: Alternatives typically provide less frequent and less detailed reporting than registered mutual funds and ETFs.
• Higher Fees: Management fees and performance fees are substantially higher than for traditional investment products.
• Potential Diversification Benefits: Many alternatives have low correlation to traditional asset classes, potentially reducing overall portfolio risk when included in a diversified portfolio.