Pooled Investments: Mutual Funds and ETFs | CFA Level I Portfolio Management

Today, we’re diving into the world of pooled investments, a fantastic solution for retail investors who want to enjoy the benefits of professionally managed portfolios without the need for substantial capital.

What Are Pooled Investment Vehicles?

Pooled investment vehicles combine funds from multiple investors to create a diversified portfolio. Investors receive shares or units of the portfolio based on their investment amount. These vehicles can be:

• Mutual funds or exchange-traded funds (ETFs) for smaller investments
• Separately managed accounts for larger investments
• Hedge funds or private equity funds for those with millions to invest

Mutual Funds

Mutual funds can be open-ended or closed-ended:

• Open-ended funds issue new shares when investors buy in and redeem existing shares when investors sell, typically daily. The fund’s net asset value (NAV) per share determines the share price.
• Closed-ended funds issue shares in primary market offerings, and investors cannot sell their shares back to the fund. Instead, they trade shares in the secondary market, where prices may differ from NAV.

All mutual funds charge a fee for ongoing management, expressed as a percentage of the fund’s NAV. No-load funds do not charge additional fees for purchasing or redeeming shares, while load funds charge up-front, redemption, or both types of fees.

Types of Mutual Funds

Here are some common mutual fund types:

• Money market funds invest in short-term government securities and corporate debt, with maturities from overnight to rarely over 90 days. They’re seen as very low-risk securities, often considered cash equivalents.
• Bond mutual funds invest in various fixed-income securities with longer maturities, such as government bonds, corporate bonds, high yield bonds, inflation-protected funds, tax-free bonds, global bonds, and emerging market bond funds.
• Stock mutual funds can be index funds (passively managed) or actively managed funds. Index funds aim to match the performance of a specific index, while actively managed funds try to outperform their benchmark indexes. Actively managed funds have higher fees and higher portfolio turnover, resulting in more capital gains tax liabilities.

Exchange-Traded Funds (ETFs)

ETFs are closed-end funds that trade like shares in the market. They have unique provisions that help keep their market price close to the NAV per share of the portfolio. Some differences between ETFs and open-end funds include:

• ETFs can be sold short, purchased on margin, and traded at intraday prices, while open-end funds are typically traded only daily based on share NAV.
• ETF investors pay brokerage commissions and bid-ask spreads, while some mutual funds charge upfront and/or redemption fees.
• ETF investors receive dividend income in cash, whereas open-end funds may offer the option to reinvest dividends in additional fund shares.
• When an ETF investor sells shares, the shares go to another investor, so the fund doesn’t need to sell underlying securities. In contrast, when an open-end fund investor redeems shares, the fund must sell the underlying securities, resulting in potentially higher turnover and capital gains tax liabilities.

Choosing Between Mutual Funds and ETFs

When deciding between mutual funds and ETFs, consider factors such as:

• Investment strategy: passive (index funds) or active management
• Trading flexibility: intraday trading (ETFs) or daily trading (open-end funds)
• Fees: management fees, load fees, and brokerage commissions
• Tax considerations: capital gains tax liabilities due to portfolio turnover
• Dividend reinvestment preferences

Separately Managed Accounts

Separately managed accounts are not pooled investments, despite being included in this section of the CFA curriculum. They are portfolios owned by a single investor, often an institution or wealthy individual. There are no shares issued since the single investor owns the entire account.

The account is managed by an investment professional who tailors the portfolio to the client’s investment objectives, risk tolerance, and tax situation. Unlike pooled investments, the underlying assets are owned directly by the investor. The main drawback is the high minimum investment requirement, usually at least $100,000 or more.

Hedge Funds, Private Equity Funds, and Venture Capital

Hedge funds, private equity funds, and venture capital are pooled investments available only to qualified investors. Minimum investments are typically between $250,000 and $1 million. We’ll provide a brief overview here, but they are covered in more detail in the course on alternative investments.

Hedge Funds

Hedge funds are pools of investor funds that are less regulated than mutual funds. Major hedge fund categories are based on the investment strategies they pursue, such as:

• Long-short funds
• Fixed-income arbitrage funds
• Convertible bond arbitrage funds
• Event-driven funds
• Global macro funds

Private Equity and Venture Capital Funds

Both private equity and venture capital funds take significant equity positions in private companies. They actively participate in the management of these companies and have a strategy to exit at higher valuations.

The main difference between the two lies in the types of companies they invest in:

• Private equity (e.g., leveraged buyout funds) typically buys entire public companies and takes them private, often using debt to fund the purchase. The fund reorganizes the firm to increase cash flow, pay down debt, and raise the value of its equity before selling the restructured firm or its parts.
• Venture capital funds invest in start-up phase companies, intending to grow them into valuable companies that can be sold publicly via an IPO or to an established firm.