A DEEPER DIVE INTO THE STOCK MARKET
If stocks and bonds are the ingredients of the financial markets, then derivatives and funds are the meals they make. Derivatives are complex and won’t be covered exhaustively by this blog post because we don’t think we’ll be doing much with derivatives here in the future. Funds on the other hand, will be a big part of this blog, either as a benchmark or a tool, so we’ll take a closer look at those below.
In essence, a derivative is a financial instrument that derives its value from some other financial instrument. The classic example of a derivative is an “option contract” or just an “option”.
An option contract is something that can be bought that gives the right (though not the obligation) to buy or sell a certain other asset in the future at a set price. Options exist on various financial instruments, not just stocks and bonds (e.g. currencies and commodities).
By way of example, Consider a would be Microsoft investor who sees a stock (e.g. Microsoft, trading at $110), but thinks that in the next two years it could double. He could then buy a 12-month option at or near the $110 price and, if the stock does skyrocket, then he can purchase it in the future at the discounted rate. Now, the question that arises is why he wouldn’t just buy Microsoft shares and hold them if he thought they would increase. This is a second layer of complexity to trading in options: not only are options complex instruments to begin with, valuing them against more traditional assets can be challenging. Again, this topic is for another day, if at all, on this blog.
Considerably more digestible than derivatives, funds are simply a basket of assets managed by someone else, either passively or actively, that investors pool their money in.
The driver for these funds is that diversification is one of the pillars of investing (i.e. exposing your portfolio to many different businesses of many different sizes in many different industries so you are not ruined by a single event that might affect one company or one industry). While diversification is the desire of most investors, actually building and maintaining a
diverse portfolio is difficult, time consuming, and expensive.
There are a few mainstream “funds” that often float around in common discussions that most people at least know exist:
Exchange traded funds (ETFs)
Hedge funds and mutual funds are both actively managed funds while ETFs are typically passively managed. Hedge funds and mutual funds should be discussed first, because these pre-date the creation of ETFs.
Mutual funds and hedge funds are both investment vehicles where investors pool their funds together and entrust a manager to grow it for them. However, the similarities end pretty much at that point. The following are some general differences (read, each fund is unique and some of them go against these trends, but these are true for a large portion of each type):
Goals/risks: the goal of a mutual fund is to beat the benchmark index they are in, while the goal of a hedge fund is to maximize returns for investors. As such, the risk appetites for mutual funds and hedge funds are considerably different, with hedge funds employing riskier strategies.
Strategies: further to the above point, mutual funds generally just purchase and sell shares and benefit from appreciation and distributions. Hedge funds, on the other hand, often take “short” positions in stocks (which pay off when markets decline), and invest in derivatives.
Investors: mutual funds are designed so anybody can invest in them, with minimum prices to buy in sometimes less than $10, while hedge funds are designed for limited investors with significant wealth (often $1,000,000 or more).
Management: for hedge funds, there is a requirement that managers have a substantial investment in their own fund, to ensure they have “skin in the game”, to act as a check on their potentially aggressive moves. Mutual funds have no such requirements.
Fees: mutual fund managers are compensated based on a percentage of assets under management, while hedge fund managers are paid based on their performance.
Exiting: getting out of a mutual fund is often as easy as logging onto your trading account and selling on the open market. Conversely, hedge funds often have limited windows in a year when investors can exit the fund and long lock-in periods.
While some version of investment funds have been around for at least a few hundred years, exchange traded funds (or ETFs) are much newer, having only been around since the early 1990s, as a tool to track certain indices, asset classes, commodities, etc.
Calling ETFs passive funds is a bit of an exaggeration, as there will still be a fund manager. However, for mutual funds and hedge funds, the manager makes decisions based on what they think will lead to the biggest rewards. Conversely, for ETFs, the fund manager’s role is merely to ensure that the ETF is tracking its benchmark properly, which is much less intensive than executing complex trading strategies. As such, the largest reward to investing in ETFs is their low fees, often below 0.5%. So an investor can obtain great diversification with only a few ETF purchases, though they are, at least theoretically, giving up the management expertise of hedge fund and mutual fund managers.
If diversification is a primary goal of investing, and funds are the easiest way to achieve that end, and the low fees of ETFs are one of their biggest benefits, all of this begs the question, are active managers worth the fees they charge? That will be discussed in our next blog post next week.