THE H. KENT BAKER INVESTMENTS SERIES
THE SAVVY INVESTOR’S
GUIDE TO POOLED
INVESTMENTS
Mutual Funds, ETFs,
and More
THE H. KENT BAKER INVESTMENTS SERIES
THE SAVVY INVESTOR’S
GUIDE TO POOLED
INVESTMENTS
Mutual Funds, ETFs,
and More
Emerald Publishing Limited
Howard House, Wagon Lane, Bingley BD16 1WA, UK
First edition 2019
Copyright © 2019 Emerald Publishing Limited
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British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN: 978-1-78973-216-0 (Print)
ISBN: 978-1-78973-213-9 (Online)
ISBN: 978-1-78973-215-3 (Epub)
CONTENTS
1.1. What Is a Mutual Fund and How Does It Work?
1.2. How Does a Mutual Fund Differ from a Separately Managed Account (SMA)?
1.3. What Is the Demand for Mutual Funds and Who Owns Them?
1.4. Why Should Investors Consider Owning Mutual Funds?
1.5. What Are the Disadvantages or Drawbacks of Owning Mutual Funds?
1.6. What Is the Minimum Investment Required in a Mutual Fund?
1.7. What Types of Mutual Funds Are Available to Investors?
1.8. What Is the Difference between Actively and Passively Managed Mutual Funds?
1.9. What Is Socially Responsible Investing?
1.10. What Are the Pros and Cons of Investing in Socially Responsible Mutual Funds?
1.11. How Can Investors Choose between Different Types of Funds?
1.12. How Are Mutual Funds Classified Based on their Portfolios?
1.13. What Costs and Fees Are Associated with Owning Mutual Funds?
1.14. What Types of Risks Do Mutual Fund Investors Face?
1.15. What Are Potential Strategies for Investing in Mutual Funds?
1.16. What Factors Should Investors Consider When Evaluating a Mutual Fund?
1.17. What Metrics Are Available for Evaluating Mutual Fund Performance?
1.18. What Is the Manager’s Incentive for Exceptional Performance?
1.19. What Regulations Govern Mutual Funds?
1.20. Why Are Mutual Funds Not FDIC-insured?
1.21. How Are Mutual Fund Investments Protected?
1.22. How Liquid Are Mutual Funds?
1.23. What Common Questions Should Investors Ask before Investing in Mutual Funds?
1.24. How Do Investors Make Money from Investing in Mutual Funds?
1.25. What Traps Do Mutual Fund Investors Face?
1.26. What Are Some Online Resources for Mutual Funds?
2.1. What Is An ETF and How Does It Work?
2.2. Why and How Did ETFs Evolve?
2.3. How Are ETF Shares Created and Redeemed?
2.4. What Strategies Do ETF Sponsors Use to Create ETFs and Track Indexes?
2.5. How Do ETFs Differ from Open-End Mutual Funds?
2.6. What Is the Demand for ETFs?
2.7. What Factors Have Contributed to the Growth of the ETF Industry?
2.9. Why Settle for Just “Average” Performance?
2.10. Why Does Indexing Outmaneuver the Best Minds on Wall Street?
2.11. What Are the Disadvantages or Drawbacks of Owning ETFs?
2.12. Which Are Better – ETFs or Mutual Funds?
2.13. What Are the Major ETF Asset Classes and Categories?
2.14. What Are Some Risks Associated with Investing in ETFs?
2.15. Who Should Consider Using ETFs?
2.16. What Selection Criteria Should Investors Use before Buying ETFs?
2.17. What Are Some Online Resources for ETFs?
3.1. What Is a CEF and How Does It Work?
3.2. How Does a CEF Differ from a Mutual Fund?
3.3. How Does a CEF Differ from an ETF?
3.4. What Is the Demand for CEFs and What Investments do CEF Investors Own?
3.5. Why Should Investors Consider Owning CEFs?
3.6. What Are the Disadvantages or Drawbacks of Owning CEFs?
3.7. What Types of CEFs Are Available to Investors?
3.8. Who Manages CEFs and What Are Some of the Largest CEFs?
3.9. What Are Some Risks Associated with Investing in CEFs?
3.10. Who Should Consider Owning CEFs?
3.11. What Does the Fee Structure Look Like for CEFs?
3.12. What Metrics Can Be Used to Evaluate a CEF’s Performance?
3.13. What Selection Criteria Should Investors Use before Buying a CEF?
3.14. Why Do Investors Often Compare the Market Prices of CEFs to Stocks?
3.15. Why Can CEFs Trade at a Different Value − a Premium or a Discount − from their NAVs?
3.17. What Types of Securities Are CEFs Permitted to Hold?
3.18. What Resources Are Available for Learning More about CEFs?
4.1. What Is a Unit Investment Trust (UIT) and How Does It Work?
4.2. Who Organizes UITs? Who Are the Key Participants? What Are their Roles?
4.3. What Are Some Features of UITs?
4.4. How Do Mutual Funds, ETFs, CEFs, and UITs Differ?
4.5. What Advantages Do UITs Offer Investors?
4.6. What Disadvantages or Drawbacks Do UITs Have?
4.7. What Are the Major Types of UITs?
4.8. What Selection Criteria Should Investors Consider before Buying a UIT?
4.9. How Can Investors Evaluate a UIT’s Performance?
4.10. Who Should Invest in UITs?
4.11. How Do Investors Buy, Sell, or Switch Units of a Trust?
4.12. How Are Individual Securities Chosen for a Trust?
4.13. What Are the Registration Requirements for UITs?
4.15. How Do UITs Trade on the Secondary Market?
4.16. What Choices Do Investors Have When a Trust Matures?
4.18. What Fees and Costs Are Associated with Owning UITs?
5. Real Estate Investment Trusts
5.3. What Criteria Must a Company Meet to Qualify as a REIT?
5.4. What Are the Forms of a REIT Distribution?
5.5. What Are the Main Types of REITs?
5.6. How Do Publicly Traded and Non-Traded REITs Differ?
5.7. What Are the Major REIT Sectors?
5.8. How Do Investors Buy and Sell REITs?
5.9. How Do REITs and their Investors Make Money?
5.10. What Are the Advantages of Owning a REIT?
5.11. What Are the Disadvantages or Drawbacks of REIT Ownership?
5.12. Why Do Traditional Metrics Not Work Well When Evaluating REITs?
5.13. What Are the Common Metrics Used to Assess REITs?
5.14. What General Factors Should Investors Consider When Evaluating a REIT?
5.15. Who Should Invest in REITs?
5.16. How Have REITs Performed Over Time, and What Factors Drive REIT Performance?
5.17. How Can Changes in the Level of Interest Rates Affect Publicly Traded REITs?
5.18. What Is the Economic Impact of REITs?
5.19. What Factors Contribute to REIT Earnings and How Are Earnings Measured?
5.20. How Much of an Investor’s Portfolio Should Be REITs?
5.21. What Questions Should Investors Ask before Investing in REITs?
5.22. What Are Some Online Resources for REITs?
LIST OF FIGURES
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Chapter 1 |
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Chapter 3 |
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Chapter 5 |
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LIST OF TABLES
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Chapter 3 |
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Chapter 4 |
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ABOUT THE AUTHORS
H. Kent Baker, DBA, PhD, CFA, CMA, is a University Professor of Finance in the Kogod School of Business at American University. He is an award-winning author/editor of more than 30 books, including Investor Behavior – The Psychology of Financial Planning and Investing and Investment Traps Exposed – Navigating Investor Mistakes and Behavioral Biases. With nearly 300 other publications, Professor Baker is among the top 1% of the most prolific authors in finance.
Greg Filbeck, DBA, CFA, FRM, CAIA, CIPM, PRM, is the Samuel P. Black III Professor of Finance and Risk Management and Director of the Black School of Business at Penn State Behrend, The Behrend College. He has authored or edited 10 books and published more than 100 academic articles. Professor Filbeck has conducted training for professional designations for the last two decades.
Halil Kiymaz, PhD, CFA, is the Bank of America Professor of Finance in the Crummer Graduate School of Business at Rollins College. He maintains an extensive research agenda and has published more than 85 articles in scholarly and practitioner journals and four books. Professor Kiymaz has received several research awards and is the Finance Area Editor of the International Journal of Emerging Markets.
ACKNOWLEDGMENTS
If there’s a book that you want to read, but it hasn’t been written yet, then you must write it.
Toni Morrison
We took Toni Morrison’s advice to heart and wrote The Savvy Investor’s Guide to Pooled Investments – Mutual Funds, ETFs, and More. Many people played an important role in this process. We thank our partners at Emerald Publishing for their many contributions, especially Charlotte Maiorana (Senior Editor) and Nick Wolterman (Assistant Editor). We also appreciate the research support provided by our respective institutions – the Kogod School of Business at American University, Black School of Business at Penn State Behrend, and Crummer Graduate School of Business at Rollins College. Finally, we dedicate this book to our families: Linda and Rory Baker; Janis, Aaron, Andrea, Kyle, and Grant Filbeck; and Nilgun and Tunc Kiymaz.
INTRODUCTION
Investing can be a murky business, like driving on a foggy day on an unfamiliar road. It’s easy to get confused and you may want to turn around and return home. However, don’t stop driving just because weather conditions are not always ideal. Learning how to become a savvy investor is not as hard as it may seem. Once you get through the murky parts, your trip won’t be as daunting and you’ll also enjoy a smoother and safer ride to reaching your financial goals. As Warren Buffet notes, “Investing is simple, but not easy.”
Are you someone who has a relatively small amount of money to invest? If so, you may think that you have only a few investment choices, but you’d be wrong. One of the most common ways to invest is through a pooled investment vehicle (PIV). A PIV is an investment fund that commingles the monies of many different investors to buy a portfolio that reflects a particular investment objective. Thus, PIVs are formed by aggregating relatively small investments from many individuals who want to participate in investments that would otherwise be available only to large investors. A wide range of PIVs are available that invest in different assets with distinctive investment strategies. Investing in PIVs can be more accessible and less risky than directly buying shares in individual companies or real assets such as real estate.
PIVs offer many inherent benefits of being part of a group of investors. Perhaps, the most important advantages are professional management and diversification. Additionally, most PIVs are subject to government oversight and many offer high liquidity, which describes the degree to which you can quickly buy or sell an asset or security market without affecting its price.
Of course, investing in PIVs isn’t without some disadvantages. Two major drawbacks involve costs and a lack of choice and control. In investments, there’s an old saying that “There’s no such thing as a free lunch,” meaning that you don’t get something for nothing. You can’t invest in PIVs for free. Hence, PIVs charge fees and expenses that eat up part of your returns. Although you can select the PIV in which to invest, you don’t have any control over the types of individual holdings that make up the fund. Thus, you can’t customize your portfolio. You also have less control over the recognition of income as well as gains and losses for tax purposes.
You should keep in mind that all PIVs, just like all other types of investment, carry risks. Different PIVs have different levels of risk. Thus, before selecting any PIV, you should be sure it offers the right level of risk for you. That is, the PIV could be consistent with your risk tolerance, which is the degree of variability in investment returns that you are willing to endure. If you don’t have a realistic understanding of your ability and willingness to tolerate large swings in the value of your investments, you are likely to take on too much risk and possibly panic and sell at the wrong time.
Given that you are ultimately responsible for your investment decisions, you need to avoid the common pitfall of investing in something that you don’t understand. This is where The Savvy Investor’s Guide to Pooled Investments comes into play. Although many different PIVs are available, this book focuses on PIVs that are readily available to the general public. For example, you don’t need much money to gain entry into open-end funds (OEFs) also called mutual funds, exchange-traded funds (ETFs), closed-end funds (CEFs), unit investment trusts UITs), and real estate investment trusts (REITs). OEFs, CEFs, and UITs have been around for many decades compared to ETFs and REITs, which are relatively recent innovations in the fund business. Although OEFs are by far the largest, this fact doesn’t mean that they are always your best choice or that you should ignore other PIVs.
Each PIV shares some fundamental similarities. For example, each investor is a stakeholder in every investment the fund makes in proportion to the size of that investor’s holdings in the fund. Yet, distinct differences exist among each PIV in the pooled fund menagerie. Before choosing among PIVs, you should understand the distinctive characteristics of each investment. Remember: Don’t ever put money in something you don’t understand. As multi-billionaire Warren Buffett notes, “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”
The Savvy Investor’s Guide to Pooled Investments offers a practical guide to anyone interested in gaining a basic understanding of PIVs. It uses a question and answer format to delve into issues that investors want and need to know before choosing a particular PIV. This handy and concise guide helps to uncover the nuances associated with PIVs. Each chapter clearly defines a particular PIV, discusses how it works, explains its advantages and disadvantages, specifies what type of investor is best suited for investing in a specific PIV, and sets forth criteria for selecting a PIV and evaluating its performance. If you are interested in becoming a savvy investor in pooled investments, this book is intended for you.