There are many different investment strategies and financial instruments available to investors, each with its own benefits and risk factors. This article outlines some of the basic similarities and differences between certain types of investments commonly referenced in financial and news media. This article is intended to be helpful for those new to investing and also individuals looking to widen their financial understanding. If you have any questions regarding your investments, please feel free to contact Athelon Wealth Management at 347-706-1414. You may also visit the firm’s website at athelonwealth.com for more information.
Equities (Publicly-Traded Stocks)
Purchasing the stock of a company provides investors with an ownership interest in a public company. It gives the investor an opportunity to participate in the appreciation and depreciation in the price of the stock over time. Additionally, stockholders may receive dividends, which are distributions of corporate profits made at the discretion of a company’s management. Equity securities tend to be highly liquid and can often be bought or sold electronically within seconds. This also means that equity prices can fluctuate significantly within a short period of time. News reports, public company filings, and even rumors can cause the price of a single stock to rise or fall in value. As such, investors are strongly urged to diversify their investments when holding individual equities to minimize risk within their portfolios.
Mutual funds are pooled investment vehicles which allow investors to hold diversified portfolios and have them managed by professional fund managers. These funds may offer a wide variety of strategies and may hold equities, bonds, and derivatives such as options and futures. Although mutual funds offer diversification across geographies, risk levels, or asset types, investors may often hold a combination of several different funds to maximize returns and protect their portfolio against losses. Mutual funds usually charge lower management fees than hedge funds, and are more liquid in that they generally allow for purchases and sales within one business day. Investors should, however, be mindful of sales charges (also known as “loads”) which may be assessed when buying or selling shares of some mutual funds. Such sales charges, if applicable, are typically disclosed in a particular fund’s prospectus.
Index funds are mutual funds which are designed to match the performance of a market index. As an example, a mutual fund may be intended to track the Russell 3000 Index. Such funds are usually passively managed, and as such, tend to capture the increases in the underlying index. These funds, however, are generally not protected against sharp declines in the value of the underlying index. Index funds typically charge lower management fees than ordinary mutual funds because their strategies are mostly dictated by the underlying index. As a result, portfolio turnover may be less frequent and transactions may even be automated to closely mirror the performance of the underlying index.
A private equity investment allows an investor to purchase shares of a company which are not traded on a stock exchange. These shares are often purchased through a direct investment into the private entity or through a private equity fund, which invests in private companies as an intermediary on behalf of its investors. Generally, private equity investments offer less transparency than public companies because they are not subject to the same strict disclosure requirements. This means that obtaining timely financial information for purposes of analysis may be difficult and time-consuming. Additionally, private equity investments are generally less liquid and may require investors to commit their capital for months or even years before shares may be sold. As with hedge funds, investments in private equity may be limited to institutions and individuals who meet certain income and net worth criteria.
Exchange-Traded Funds (ETFs)
Exchange-Traded Funds combine the active management element of mutual funds with the increased liquidity of publicly-traded stocks. While a purchase or sale of mutual fund shares may take one business day, ETFs may be purchased and sold within seconds. While some ETFs offer exposure to various conservative investment strategies, others may utilize derivatives and leverage with the goal of magnifying returns for investors. Lately, demand for more aggressive investment vehicles has led to the creation of leveraged ETFs, which amplify the performance of an underlying index by a factor of 2 or 3. This means that a 5% increase in the underlying index can result in a 15% increase in the ETF. Such leveraged ETFs are meant to be held only for short time periods as they are reset on a daily basis. As a result, a long-term investor looking to capitalize on appreciation in the underlying index would generally be highly disappointed if attempting to use leveraged ETFs to accomplish their desired returns.
Hedge funds are similar to mutual funds in that they are pooled investment vehicles which provide active asset management. The difference, however, lies in the liquidity and transparency when compared to mutual funds. The public disclosure requirements for hedge funds are minimal and do not provide a complete picture of the underlying investments or strategies being used by the investment manager. Hedge funds also charge higher fees than mutual funds, with “2/20” being the most common fee structure. It means that the fund charges 2% of asset under management annually, and also charges 20% as a performance fee. A hedge fund utilizing such a fee structure would allow the fund to keep 20 cents of every dollar earned by investors. This policy does not work in reverse, as investors are made to absorb all losses incurred by the fund. In general, direct investment in hedge funds may be limited to institutions and individuals who meet certain income and net worth criteria.
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (also known as REITs) provide investors with an opportunity to participate in the revenue earned from hotels, office buildings, residential properties, interests in mortgage securities and other assets held by the Trust. Essentially, investors act as a conduit and provide the REIT with the capital necessary to purchase the underlying assets with the intent of collecting future payouts.
As the process of purchasing and selling real estate can be complex, time-consuming, and costly, REITs often require investors to lock in their investment for a certain period of time before they can exchange their shares for cash. While some REITs are relatively illiquid and non-marketable, there are also marketable REITs that offer additional liquidity and those that are publicly-traded on stock exchanges.
Bonds allow investors to collect interest paid on corporate and governmental debt. Interest may be paid periodically in cash, or through a single appreciated amount in the future (zero-coupon bonds). Unlike dividends, entities that issue bonds are required to make the payments to the debt-holders as described in the issuing documents. Bonds may produce a more steady income stream than holding stocks. However, they are subject to credit risk, as the ability of the issuing entity to make its payments in a timely manner is tied directly to its financial stability. Therefore, riskier entities will generally issue debt which pays a higher percentage return than more financially stable entities. In addition, bonds are subject to interest rate risk in that bond prices tend to fluctuate in relation to changes in market interest rates. As such, investors are strongly urged to diversify their investments when holding individual bonds to minimize risk within their portfolios.
Alexander Efros, MBA, CPA
President / Founder
Athelon Wealth Management, LLC