Demystifying the common financial assets: Funds
Mutual Funds, Exchange Traded Funds (ETFs), Endowment Funds, Pension Funds, Hedge Funds, Private Equity, Venture Capital...
We’ll wrap up our series on demystifying the common financial assets by talking about funds. As a non-finance professional, you may have heard of them in the news and think of them as mysterious, complex entities, but in reality it’s fairly simple to grasp how funds work at a general level.
Simply put, a fund is a structure used by a group of investors pooling their money together to pursue a specific investment strategy with the expectation of growing their capital, and in some cases, generating cash for future expenses. A professional individual or firm known as the fund manager is entrusted with the responsibility of executing on the said investment strategy and is compensated for it.
All funds share the following common characteristics:
The group of investors who commit their capital, in some contexts also referred to as Limited Partners,
The investment strategy they seek to pursue.
The Fund Manager(s) executing on the investment strategy, in some contexts also referred to as General Partners.
Rules enforced via contractual arrangements between investors and managers, or imposed by regulators that define the rights and limitations of investors and managers.
Let’s look into each of these characteristics.
Who are the investors?
In advanced economies, the majority of people are either directly/voluntarily or indirectly/involuntarily an investor in some fund.
You may ask, “Wait, how can there be involuntary participation?”
The majority of the workforce has a certain portion of their wages deducted from their paycheck and contributed to a pension fund, 401(k) account or national insurance fund. Involuntarily, because this contribution is often deducted from the paycheck by the employer and the employees often have little recourse to say no. Technically making each employee an “investor” in the pension fund, even though most people wouldn’t see themselves that way.
People can also choose to directly invest their savings in some funds.
The fund management industry commonly categorizes investors into two categories: Individual and Institutions.
Individuals, as the name suggests, are people directly investing their money. Institutions are larger companies, and often other funds, investing their capital. A fund can have the mandate to invest in other funds as part of its investment strategy.
Regulators and industry participants further sub-divide the “Individuals” category into Retail and “High Net Worth (HNW) ” or “Accredited” investors.
The average person on the street would fall into the retail category whilst rich people with net worth and/or assets beyond certain thresholds fall into HNW or accredited category. This distinction is often enforced by regulators to prevent funds, like private equity or venture capital, that pursue riskier strategies from marketing to common folks that may not have a full understanding of what they may be getting into.1
The investment strategies that funds commonly pursue
Funds are classified into different categories like pension funds, mutual funds, hedge funds on the basis of their stated objectives and the investment strategies they pursue in line with these objectives.
A pension fund e.g. California State Teachers Retirement System (CalSTRS) invests the pension contributions of its contributors (i.e. public sector educators of the state of California) in order to pay the contributors (educators) a regular pension when they retire. The pension fund pursues the dual goals of (1) earning a capital return on accumulated pension contributions that at least keeps up with inflation and (2) generating cash flows that can be distributed to pensioners every month.
Similarly an endowment fund for a non-profit organization or a university invests its capital in order to fund future operational expenses of the organization, or future capital investments such as a new research centre or housing block, or affiliated social-causes such as scholarships for deserving students.
Pension funds and endowment funds often pursue diverse investment strategies by either investing in other funds (a fund-of-funds approach) or directly in a portfolio of assets comprising stocks or bonds of blue-chip companies, government and municipal debt, infrastructure projects etc.
Mutual Funds market themselves as a savings product to the general public i.e. retail investors; an alternative to bank saving accounts. The general public invests their money in mutual funds by buying units of a mutual fund. The fund manager then invests that money according to the stated investment strategy of the fund. Since mutual funds are marketed to retail investors, the strategies they pursue are generally safer. Mutual funds tend to invest mostly in highly liquid and safer government bonds and/or stocks of companies on the stock exchange. The fund manager decide which exact stocks and/or bonds and in what proportion will the mutual fund hold to pursue the stated investment strategy.
You can take a strong guess at the strategy of the mutual fund just from their naming. To take a few examples from Pakistan, the HBL Cash Fund will seek to give its investors a return closest to holding cash and thus invest its capital in highly liquid assets like short-term government bonds or short-term loans to investment-grade corporations. The UBL Government Securities Fund will likely offer returns similar to government bonds and thus only invest in government securities. Differently from the cash fund, this fund may also invest in longer-term government bonds that offer a slightly higher return. The UBL Stock Advantage Fund will seek to offer returns that can be achieved via investing in stocks of listed companies. You can reasonably expect the Cash Fund to be relatively lowest risk and lowest return between the three examples, the Government Securities Fund to be in the middle and the Stock Advantage fund to be the relatively highest risk and return.
Exchange-Traded Funds (ETFs) are a further evolution of the idea of mutual funds. ETFs are also available to retail investors to invest in. An ETF will seek to passively track a specific index of securities. To further understand how tracking works for ETFs, I’ve shared an example in the appendix to this post. The tracking is passive because it’s purely based on mathematical rules and there’s no active judgement or decision making by a fund manager involved.
The SPY ETF tracks the S&P 500 stock market index and the QQQ ETF tracks the Nasdaq 100 stock market index, with these two being amongst the most popular and widely traded ETFs. Any investor that wants to invest their money to simply track the same returns as the stock market indices can buy units of the corresponding ETF from the exchange.
ETFs aren’t just restricted to stock market indices or equities. ETFs can be created to track any asset-class which is highly liquid and priced frequently such as government bonds, commodities, currencies, cryptocurrencies etc.
Hedge Funds invest their money in relatively liquid assets like bonds and listed stocks but they also choose to pursue riskier strategies such as short-selling, investing on leverage, activist investing and investing in complex financial derivatives like options, warrants and convertible bonds. Hedge funds take on more risk than mutual funds or pension funds with expectation of earning above-market returns.
Private Equity and Venture Capital funds both invest money by purchasing ownership stakes of private companies or companies that aren’t listed on the stock exchange. In this manner both are similar but they differentiate themselves in the kinds of companies they invest in and how they’d work with their portfolio companies.
Private Equity strategies include: Buying mature companies that are losing market share for a low price, turning it around by replacing management, introducing better technology and operational processes and selling it at a higher price when the company’s efficiency improves; Buying out a public company whose market capitalization is lower than the sum of its component assets, breaking it up and selling assets like real-estate, plant equipment, trademarks, intellectual property individually with the hope of fetching more from the sales than what was used to buy out the company; Buying out many smaller-sized companies such as individual nursing homes and combining them into a large, single entity with shared administrative resources.
Venture Capital (VC) funds will seek to fund entrepreneurs and early-stage startup companies, often technology companies that are expected to rapidly grow and acquire market share. VC funds seek to acquire a sizable stake in an early stage company for a lower price and later sell that stake for a higher price after the company goes through a period of rapid, early-stage growth. VC funds seek to follow a power-law dynamic where they know that if they’d invest in 10 early-stage companies, 5-6 will fail, 2-3 will just be able to return the initial investment and 1-2 would provide spectacular 10x+ returns that would return more than the original investment of the entire fund.
Both Private Equity funds and VC funds will seek to exit their ownership of their portfolio companies via listing the company on the stock exchange via an IPO, or either another company acquiring the company, or have the company buy-back its shares or sell their stake to other investors in a secondary round. Exits are crucial for these funds to be able to return capital back to their investors.
Private Credit funds are a relatively newer class of funds that lend money in arrangements which banks and bond investors would not typically enter. These funds would lend money at much higher interest rates in riskier arrangements in their hopes of earning above-market returns.
Hedge funds, Private Equity, Private Credit and Venture Capital funds don’t raise money from retail investors. They primarily seek out capital from institutions, often other funds, and high net-worth individuals.
Who runs the fund
Professional asset management companies set up and run funds on behalf of the investors in the funds.
The Harvard Management Company (HMC) runs Harvard University’s endowment fund. The California Public Employees' Retirement System (CalPERS) is an agency of the California state government that "manages pension and health benefits for more than 1.5 million California public employees, retirees, and their families"2
T. Rowe Price Blue Chip Growth Fund is a mutual fund run by the firm T. Rowe Price. The fund's stated objective on its website is “ ...to provide long-term capital growth. Income is a secondary objective.” Teams of portfolio managers, analysts and associates employed by T. Rowe Price would be involved in making decisions of where the fund would choose to invest. Additional support teams will provide accounting, reporting, marketing, regulatory and other affiliated services.
The popular SPY ETF that tracks the S&P 500 stock index is managed by State Street Global Advisors. However, unlike the Blue Chip Growth mutual fund where teams of analysts, advisors and portfolio managers decide where to invest the fund’s capital, for the SPY ETF the capital allocation decision is made entirely algorithmically based on the composition of the S&P 500 index. State Street Global Advisors likely only maintains the plumbing of the ETF and provides basic administrative services. This is the main reason why ETFs are a lot cheaper for investors than mutual funds.
Renaissance Technologies, a hedge fund firm widely known for quantitative and systematic investment strategies, runs the Medallion fund as its flagship fund. The private equity firm KKR raised $19 Billion for its flagship KKR North America Fund XIII.
Common rules and Policies governing these funds
Open-ended vs Closed funds
Open-ended funds allow investors to deposit or withdraw capital from the fund at any time. The redemption policies of a fund would significantly influence how liquid that fund is as an asset to its investors.
ETFs are generally highly liquid. You can buy and sell ETFs within a few seconds during trading hours. Mutual funds are also fairly liquid where they can issue more or buy back shares from investors at the end of each business day.
Closed-ended funds only raise capital from investors once, or in defined windows, and outside of these windows, typically do not take on more funds. Similarly, they also only return capital to investors during specific windows, events (i.e. exit from an investment) or when the funds close down. As an investor, the fund will not buy back your stake in the fund on your demand but you can choose to sell your stake to another investor in the secondary market. Private Equity and Venture Capital funds are generally closed-ended.
The redemption policies of hedge funds can vary between the spectrum of open-ended vs closed-ended based on specific agreements. Some can be open-ended, some closed and some in between where they can allow investors to withdraw capital with a notice period.
Compensation Policy and Expense Ratios
Fund Managers are compensated by investors for their efforts towards executing on the investment strategy of the fund. The fee component typically includes a percentage on overall assets under management, a percentage of returns beyond a specific threshold, and sometimes fees on adding or withdrawing capital from the to/from the fund. The total annual expenses for manager fees expressed as a ratio to total assets in the fund is known as the expense ratio.
Amongst the different kinds of funds, ETFs have the lowest expense ratios (often 0.03%-0.25%). Mutual funds and pension funds are typically in the 0.5% to 1.5% bracket.
The most common fee policy for hedge funds, private equity and venture capital funds is called the 2 and 20 i.e. annually 2% of assets under management and 20% of returns beyond the performance threshold. Some funds with exceptional performance can choose to charge much higher than this e.g. Jim Simons' Medallion Fund, a flagship of Renaissance Technologies, charges a 5% annual management fee and a 44% performance fee. Newer firms or managers just starting out without a longer track record can also charge lower to entice investors to back them.
Conclusion
There is of-course a lot more nuance, varying legal arrangements and investment strategies followed by funds across the globe. We’ve only touched the surface in the brief primer. If you would like me to go deeper in a particular aspect, please share your feedback in the comments to this post.
To close off, here’s a summary table, or a cheatsheet, for all the different kinds of funds we discussed earlier.
Appendix
How tracking works for ETFs
I can create a stock market index called TOP3 that comprises the top 3 companies and weighted by the market capitalization of each company.
The index comprises Apple, Microsoft and Nvidia stock prices by proportions of (33.7%, 35.6% and 30.7%) determined by the relative market caps. On creation date, I set the base value of the index to 100.
I can also create an ETF called T3 that will track my TOP3 index, which simply means that on the present day, $1000 invested in the T3 ETF will be used to buy Apple, Microsoft and Nvidia stock worth $337, $336 and $307 respectively.
On the next trading, the prices of each company changes as follows:
The value of the index changes due to the changes in the underlying stock prices. The value of T3 will also change in the same manner. The $1000 invested the day before will now be worth $1007.63.
Due to the change in stock prices, which changes market caps, the proportions for each company’s stock in the index will also change.
So the T3 ETF will have to re-balance itself to the new proportions by adding more Apple and Microsoft stock and reducing Nvidia stock. This pattern then repeats for each trading day.
The T3 ETF tracks the TOP3 index every day.
Is this too paternalistic for a free society and does it entrench economic inequality by limiting access for common folks to investment strategies otherwise available to the rich? That can be a good topic to debate on.
https://en.wikipedia.org/wiki/CalPERS
Love this!