I was once an avid self-investor. I used to be the investment advisor for my colleagues. I was successful at it, till I compared my return with that of some mutual funds I bought on the side. It was a pleasant awakening; I was nowhere close to their performance. Then came 2008 when I watched my investments in Washington Mutual bank stocks disappear within few minutes, in front of my eyes!
It didn’t take it long to realize I was not a great expert in stock picking. Fund managers were far better. Since then all of my new investments have been either in Mutual Funds or in Exchange Traded Funds. Not only these two, there’s another kind of fund that is still out of my reach, for not having enough investible asset, the Hedge Funds.
We will talk about facts, pros and cons of these three types of funds in this article. And, I’ll make a case for leaving your investment in the hands of fund managers.
Let’s say you have some money to invest.
Depending on your age and risk-taking attitude your investment could be in stocks, bonds, CDs, Govt. Notes. For more savvy investors other investment options could be real estate, peer lending, private placement, etc.
For the young and employed investor, we recommend stock investing for the majority of your assets. Because stocks have relatively more return on investment than another form of investing. At the same time, investing in stocks is easier and there’s plenty of material out there to study a company’s performance to base your buy and sell decisions on.
But, what if you miss valuable facts. Life takes tolls someday you’ll be too busy if you miss important information your stocks might become toxic for you. Or you may become impulsive one day, and take a wrong buy/sell decision, which can prove to be wrong.
Just like what happened to me in 2008.
In comes the concept of funds, where you don’t buy individual stocks but rather you contribute to a common pool of money, used for stock investing, under the guidance of an experienced and qualified fund manager. You can pick a fund and let the managers and his team manage your money actively.
Yes, you pay fund manager fees, which is deducted from your gains. But you pay brokerage fees anyway to buy or sell a stock.
So how about past performance of individual investors vs. stock indexes or performance of fund managers.
Studies have demonstrated that the track record for individual investors is not encouraging. DALBAR, a leading financial services marketing research firm, released another study this past year revealing that from 1990 to 2010, the unmanaged S&P 500 Index earned an average of 7.81% annually. Over that same period, the average equity investor earned a paltry 3.49% annually!
These funds can be bought and sold through a brokerage company, like Fidelity, TD Ameritrade, etc. They are not available to buy from the stock market. Fund managers aim for beating stock indices for giving a higher return to the investors. Fund managers pull money from individual investors and make a decision on buying/selling stocks. A portion of the fund may remain liquid in the form of the money market, a portion may be invested in bonds and other fixed-income assets.
They can be generic with a mix of various stocks or can be as generic as having only health care stocks or technology stocks.
Exchange Traded Fund
They are specialized mutual funds that can be directly sold/bought from stock exchanges. A typical ETF has lesser expense ratio than a mutual fund, meaning – fewer fees towards fund managers, compared to MFs. I, for example, am mainly investing in ETFs.
Hedge funds are like mutual funds, with a difference that they can go short on certain stocks. Mutual funds buy stock which they think are undervalued. They can’t short stocks which are perceived overvalued. Hedge funds can do either. They can take a long position as well as short position. In layman term, Hedge funds can gain even during bear markets.
Why don’t we invest in hedge funds, then?
It is because they can short stocks, which can cause a major stock market crisis, regulators do not allow them to be as widely available in the market as the mutual funds or ETFs. They are not permitted to advertise themselves as well. Hedge funds can be bought only via private placement as it is only permitted to operate within a close circle of investors. often hedge fund manager’s money in also invested in that particular hedge fund.
So to invest in a hedge fund, you need to be either close to the fund manager or you need to have almost a million dollars to invest.
How popular is hedge fund investing?
It is very very popular, as per latest data – $2,82 Trillion dollars have been invested in hedge funds, but only among the riches. Naturally hedge funds do charge a premium fee for the fund managers. So in terms of fees -hedge funds are costliest.
While I am planning to seriously give it a thought, I urge you to do more research on hedge fund performance and your risk acumen. You should decide if investing in a hedge fund is good for you, now since they are very much within average investor’s reach.
Unless trading is your full-time job or you consider yourself as smart as Warren Buffet, in stock picking acumen, do not trade individual stocks. You can buy one or two for long-term investment, though. I do have few such exposure, likes of General Motors, Altria, AT&T, etc. I’ll hold on to them for very long time. But, I’ll mainly invest in the stock market via funds, mostly ETFs, for their low fees.
So, how can you convert a stock buying into a fund buying?
Giving you an example-
Now, I think, is a good time to buy BioTech stocks. So, instead of spending my time to research best biotech stock to buy, I’d simply go to fund rating agencies (Morningstar or TradeKing for example) and try to find the best performing mutual fund or ETF. Now if I buy one Biotech stock, I’d be taking on more risk as today’s leader may not be leading the industry two years from now. I’d have to be on top of latest news and trend in the biotech industry.
While buying a Biotech ETF, I am leaving that research work to expert fund managers. Now I have to on worry about a biotech industry, vis-a-vis a particular company. I can lower my risk and free up my time for other productive work.