Investment Vehicles

Investment professionals offer a great number of financial services, and products to help their clients address their investment and risk management requirements. Understanding the products and how they are structured is necessary to appreciate how the investment industry creates value for its clients. For example, an equity mutual fund is an investment vehicle that owns shares.investment vehicles how they are structured and how those structures serve investors.

That is, investors give their money to investment firms, which then invest the money in a variety of securities and assets on their behalf. Thus, investors make indirect investments when they buy the securities of companies, trusts, and partnerships that make direct investments. The following are examples of indirect investment vehicles:

• Shares in mutual funds and exchange-traded funds
• Limited partnership interests in hedge funds
• Asset-backed securities, such as mortgage-backed securities
• Interests in pension funds

Most indirect investment vehicles are pooled investments (also known as collective investment schemes) in which investors pool their money together to gain the advantages of being part of a large group.

Comparison of Direct and Indirect Investments

Indirect investment vehicles provide many advantages to investors in comparison with direct investments. Indirect investments allow small investors to use the services of professional managers, whom they otherwise could not afford to hire. Indirect investments allow investors to share in the purchase and ownership of large assets, such as skyscrapers. Indirect investments allow investors to own diversified pools of risks and thereby obtain more stable, although not necessarily better, investment returns.

Many indirect investment vehicles represent ownership in many different assets, each of which typically is subject to specific risks not shared by the others. For example, a risk of investing in home mortgages is that the homeowners may default on their mortgages. Indirect investments are often substantially less expensive to trade than the underlying assets. Although the assets in which traded investment vehicles invest may be difficult to buy and sell, ownership shares in these vehicles can trade in liquid markets.

Direct investments also present some advantages to investors compared with indirect investments. Investors who hold indirect investments generally must accept all decisions made by the investment managers, and they can rarely provide input into those decisions.

Investors choose when to buy or sell their direct investments to minimise their tax liabilities. In contrast, although the managers of indirect investments often try to minimise the collective tax liabilities of their investors, they cannot simultaneously best serve all investors when those investors have diverse tax circumstances. Investors can choose not to invest directly in certain securities for example, in securities of companies that sell tobacco or alcohol. In contrast, indirect investors concerned about such issues must seek investments with investment policies that include these restrictions.

So, is direct or indirect investment more advantageous for investors?

Consider the following examples of potential investment management problems: Investment managers who do not conduct sufficient research and due diligence may suggest inappropriate investments. Some managers have been known to sell and replace their entire portfolios once or more over the course of a year. To successfully use the services of professional investment managers, investors must control potential investment management problems.

Investors who cannot easily deal with these problems often prefer indirect investment vehicles, such as public mutual funds, for which a board of directors  has primary responsibility for monitoring the performance of the managers. Unfortunately, although board members generally work conscientiously on behalf of their shareholders, some may be more loyal to the managers that they monitor than to the shareholders that they represent. Regardless, the managers of public mutual funds generally work hard for their investors because they usually are paid in proportion to their total assets under management. In contrast, large institutional investors are often direct investors who hire and oversee investment managers.

The sole purpose of these investment vehicles is to own securities and other assets. The investment vehicles, in turn, are owned by their investors, who share in the profits and losses in proportion to their ownership. It is important to note that investors in an investment vehicle do not share ownership of the investment securities and assets held by the investment vehicle. Instead, they share in the ownership of the investment vehicle itself. That is, they are the beneficial owners of the investment vehicle's securities and assets, but not their legal owners.

How Pooled Investment Vehicles Work?

Banks, insurance companies, and investment management firms organise most pooled investment vehicles. Pooled investment vehicles are overseen by a board of directors, a board of trustees, a general partner, or a single trustee; the governance structure depends on the form of legal organisation. In some countries, directors must be independent of the sponsor that is, they are not allowed to work for the banks, insurance companies, or investment companies that organise the investment vehicle. In other countries, employees or directors of the sponsor may also serve as directors of its associated investment vehicles.

The directors appoint a professional investment management firm, which is almost always an affiliate of the sponsor. The investment manager works on a contractual basis in exchange for a management fee paid by the investment vehicle from its assets. The investment manager chooses the securities and other assets held by the investment vehicle. The three main types of pooled investment vehicles are open-end mutual funds, closed-end funds, and exchange-traded funds. An important distinction between pooled investment vehicles is whether they are exchange-traded or not. Open-end mutual funds may use active or passive investment strategies, depending on the fund.

Open-End Mutual Funds

When investors want to invest in a mutual fund, the fund issues new shares in exchange for cash that the investors deposit. When existing investors want to withdraw money, the fund redeems the investors' shares and pays them cash. The manager of an open-end mutual fund determines the prices at which deposits and redemptions occur. The net asset value  of a fund is calculated by dividing the total net value of the fund (the value of all assets minus the value of all liabilities) by the fund's current total number of shares outstanding. Investors may have to pay sales loads to the fund distributor, who markets the fund, at the time of purchase, at the time of redemption, or over time.

Front-end sales loads are fees that investors may have to pay when they buy shares in a fund. Back-end sales loads are fees that investors may have to pay when they sell shares in a fund that they have not held for more than some pre-specified period, typically a year or more. Sales loads are calculated as a percentage of the sales price. Investors pay these fees to the fund as opposed to paying them to the distributor as in a front-end or back-end sales load. These costs primarily consist of the costs of trading portfolio securities incurred when buying securities to invest the cash received from investors or when selling securities to raise cash for redemptions.

Money market funds are a special class of open-end mutual funds that investors view as uninsured interest-paying bank accounts. Unlike other open-end mutual funds, regulators permit money market funds to accept deposits and satisfy redemptions at a constant price per share (typically one unit of the local currency for example, a euro per share in the eurozone) if they meet certain conditions. In that case, regulators allow money market funds to pay daily income distributions to their shareholders, which they typically distribute at the end of the month. In particular, if investors expect that the value of their money market funds will decline in the near future, they may rush to redeem their shares before the NAV falls. These actions can be destabilising because they force funds to sell portfolio securities when the market is falling.

Closed-End Funds

Unlike open-end funds, closed-end funds have a fixed number of shares; they do not issue or redeem shares on demand. Accordingly, the total number of shares outstanding for most closed- end funds rarely changes. Listed closed-end funds sell shares to the public in initial public offerings , They then use the proceeds from the IPO to purchase securities and other assets.

After the IPO, investors who want to buy or sell a listed closed-end fund do so through exchanges and dealers. The closed-end fund does not participate in these transactions aside from registering the resulting ownership changes. Investors buy and sell the shares at whatever prices they can obtain in the market. Listed closed-end funds are actively managed and generally trade at prices different from their NAV. A fund is said to trade at a discount if the trading price is lower than the fund's NAV or at a premium if the trading price is greater than its NAV.

Discounts are more common than premiums because many closed-end fund investment managers have been unable to add more value to their funds than the funds lose through their various operational costs. The investment management fee typically is the largest of these costs.

Exchange-Traded Funds

Exchange-traded funds  are pooled investment vehicles that are typically passively managed to track a particular index or sector, although an increasing number of ETFs are actively managed. ETFs are generally managed by investment professionals who provide investment, managerial, and administrative services. The fees for these services and trading costs are low, particularly for ETFs that are passively managed.

Index funds

Index funds, which are passively managed, are among the most common types of pooled investment vehicles and are used widely in most parts of the world.

The Index Universe The investment industry has created indices to measure the values of almost every existing market, asset class, country, and sector: Broad market indices cover an entire asset class for example, stocks or bonds generally within a single country or region.

Fixed-income indices cover debt securities and vary by characteristics of the underlying securities and by characteristics of the issuers.

How to Compute the Value of Indices : the value of an index is computed from the prices of the securities that compose the index. Two important elements affect the value of an index:

• the securities included in the index
• the weight assigned to each security in the index.

Other indices try to capture a larger share of the securities market and include hundreds or thousands of securities from around the world. Note that the list of securities included in an index may change from time to time. The process of adding and removing securities included in the index is called index reconstitution.

There are different approaches used to assign weights to the securities included in an index:

• price-weighted
• capitalisation-weighted, or equal-weighted.

A price-weighted index is an index in which the weight assigned to each security is determined by dividing the price of the security by the sum of all the prices of the securities. As a consequence, high-priced securities have a greater weighting and more of an effect on the value of the index than low-priced stocks. The DJIA in the United States and the Nikkei 225 in Japan are examples of price-weighted indices.

The market capitalisation or capitalisation of a security is the market price of the security multiplied by the number of shares outstanding of the security.

Securities included in capitalisation-weighted indices are given weights in the proportion of their market capitalisations. The Hang Seng in Hong Kong, the FTSE 100 in the United Kingdom, and the S&P 500 Market Weight Index are examples of capitalisation-weighted indices. The S&P 500 Equal Weight Index is an example of an equal-weighted index.

Index Funds : the investment industry creates many investment products based on security market indices, such as index funds. An index fund is a portfolio of securities structured to track the returns of a specific index called the benchmark index.

An index fund is a passive investment strategy because the index fund manager aims to replicate the benchmark index. Other index funds find it difficult to buy and hold all of the securities included in the benchmark index. The securities may not be easily available or the transaction costs of acquiring and holding all the securities included in the benchmark index may be high. If full replication is difficult or too costly, index fund managers might invest in only a representative sample of the index securities, a strategy called sampling replication. Adjustments are necessary in the case of index reconstitution that is, when securities are added or deleted from the list of index securities.

Hedge funds

Hedge funds are private investment pools that investment managers organise and manage. The term "hedge" once referred to the practice of buying one asset and selling a correlated asset to take advantage of the difference in their values without taking much market risk thus the use of the term hedge because it refers to a reduction or elimination of market risk. Although many hedge funds do engage in some hedging, it is not the distinguishing characteristic of most hedge funds today.

Hedge funds are distinguished from other pooled investment vehicles primarily by their availability to only a limited number of investors, agreements that lock up the investors' capital for fixed periods, and their managers' performance-based compensation.

They can also be distinguished by their use of strategies beyond the scope of most traditional closed-end funds and open-end mutual funds that are actively managed. Most money invested in hedge funds comes from large institutional investors, such as pension funds, university endowment funds, and sovereign wealth funds, as well as from high-net-worth individuals.

Lock-Up Agreements : Most hedge funds lock up their investors' capital for various periods, the length of which depends on how much time the hedge fund managers expect that they will need to successfully implement their strategies.

Compensation Perhaps the most distinguishing characteristic of hedge funds is the managerial compensation system they use. Hedge fund managers generally receive an annual management fee plus a performance fee that is often specified as a percentage of the returns that they produce in excess of a hurdle rate.

Hedge fund managers usually earn the performance fee only if the fund is above its high-water mark. The high-water mark reflects the highest value, net of fees, that the fund has reached at any time in the past The high-water mark provision ensures that investors pay the managers only for net returns calculated from the initial investment and not for returns that recoup previous losses. Investors pay high performance fees in the belief that the fees provide strong incentives to managers to perform well.

Risks Although many hedge funds are not particularly risky, the high performance fees might encourage some fund managers to take substantial risks. On the other hand, if the hedge fund has poor returns, the investors lose their whole investment but the managers lose only the opportunity to stay in business.

Hedge fund investment managers often also participate as investors in their hedge funds. Their co-investments help assure their investors that the managers' interests are well aligned with theirs. Most hedge funds are open-end investment vehicles that allow new investors to buy in and existing investors to leave at the NAV.

Slahdji Mohamed Oussalem