After our first article on funds for beginners, this article will carry on the series.
Nothing written here should be considered formal tax, financial, legal or any other kind of advice advice, and is written for entertainment purposes only, in other words isn’t a solicitation to invest.
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Index Funds (Tracker Funds) are a sort of mutual funds or ETFs, which consist of stocks or bonds that try to acquire the same profits as a specific index. Hundreds, if not thousands, of indexes, track the price movements of markets and sectors daily.
In simpler terms, index funds are used for replicating the performance and health of a market.
For example, the Dow Jones Industrial Average is a broad market index, which is made of 30 blue-chip stocks. At the same time, the US Global Jets index tracks the performance of an entire sector, which is the international airline industry.
An Index can be used as a market’s benchmark, or it can be used as a way to calculate the performance of a particular sector or a market.
As an investor, you won’t be able to invest in an index directly, however, you can invest in a fund, which can be an index fund or an ETF. Generally, most index funds try to replicate the performance of an index by copying all the underlying securities of that index.
In some other cases, a fund takes the index as a sample model of securities and contains similar securities or additional investments such as options and futures. Index funds contain 40% lesser assets than those held in mutual funds.
Index funds are passively managed funds, which makes them hold to the securities in an index for increasing the profits and minimizing the costs. The underlying securities of a particular index could change, but it happens rarely.
Fund managers could trade any of the underlying security within their respective market segment as they like, which happens as an act of trying to beat the performance of the benchmark index.
Pros and cons – Some of the important features of index funds are as follows (including pros and cons).
The returns offered by index funds are the same as the index they are tracking. Additionally, you can be able to avoid the fund-management costs. In most cases, index funds have been proven to provide better profits compared to actively managed funds.
Like we mentioned earlier, the portfolio of index funds rarely changes, which leads to stable results along with low trading costs and minimal taxes.
The operational costs of index funds are quite low because there won’t be a particular need for services from portfolio managers or stock researchers. People won’t even have to pay the commissions that are created because of constant trading activity.
For example, active funds have fund management costs of around 1.3%, which means they would have to pay around $1.30 for every $100 they invest in the fund.
In general, index funds hold the same securities as the index they are tracking, which makes it clear about your fund’s holdings. This helps in calculating the index fund’s risk according to these holdings.
For example, an index fund that is tracking the oil and gas industry is considered volatile and therefore risky compared to a bond index fund.
While trying to create your own portfolio, you can be able to get access to hundreds or thousands of high-performance companies. This lets you diversify your portfolio and when a particular stock is not performing well, the chances are high that another security in the portfolio would cover the overall profits.
Coming to the drawbacks, index funds hold the same securities regardless of the market’s direction. The major purpose of the index fund is to track the index.
At any given time, the fund manager won’t be able to sell stocks that underperforming, even when there is a broad market decline.
Index funds lack flexibility, which means the funds won’t be able to offer higher returns than that of the benchmark they are tracking. When the market rises, you will be guaranteed the benchmark returns’ and vice versa.
The difference between an index fund’s profits and the performance of the benchmark index it is tracking reflects the costs for running a portfolio, which is called a tracking error.
While investing in an index fund, you must always make sure that you go for an index fund that has a smaller tracking error, when comparing the funds tracking the same index.
Indexes aren’t unbiased, they are created by companies that decide the index’s makeup. These decisions aren’t strongly regulated as they are not transparent and could be manipulated by the management tactics.
When the index funds and the benchmark index are managed by the same fund manager, there can be a conflict.
Things to consider – before investing in index funds, there are some important aspects that you should consider.
First, determine the amount of risk that you can tolerate for obtaining good returns.
Then, know about the risks involved with the fund which looks attractive and suitable to you.
You must make sure that the fund’s strategy abides by your investment goals.
Gather all the information related to things such as how much are you willing to pay for buying, owning, and selling the fund.
Compare the fund with some other funds in the respective sector and take note of the performances.
Finally, you must have an idea of how sooner you would require the invested money.
In any given case, an investor must be familiar with all the information available about a fund and its prospectus.
Index-linked ETFs – An ETF that tries to replicate the performance of a benchmark index is called an Index ETF or Index-linked ETF. Some of the examples for Index ETFs are those tracking benchmark indices such as Nasdaq 100, DJIA, S&P 500, etc.
Nowadays, Index ETFs are gaining a lot of popularity among investors as they offer access to diversified and passive indexed strategies while charging lower fees.
Important Information – Index funds, ETFs, and mutual funds are known to perform better when compared to actively managed funds. Any of these could be considered a good investment opportunity.
Yes, they are excellent investment options, yet all the three aren’t the same, and therefore, you will be required to do some groundwork.
However, some people might have the necessary amount of knowledge to grasp all this information, yet some might it hard to understand such financial terms.
Even if a person understands everything, investing is a very complex process and not suitable for everyone. For example, if you are a doctor, you might not concentrate on your work and continue to manage all your investments at the same time.
Similarly, some people who are dedicated to their line of work or are passionate about their business endeavors, might not get the leisure to indulge in activities related to investing.
In such cases, it is better to have a reputational financial planner or investment advisor such as us to take care of all your investment needs. We can also train you so that you can take care of your investments by yourself.
Examples – FTSE 100 tracker fund is a good example for the low-cost index funds, which track the performance of the UK’s largest stock market index known by the name of ‘FTSE 100’.
While the FTSE 100 index fund’s index comprises 100 of the largest companies in the UK, the FTSE 250 index consists of the 250 of the largest companies after the first 100.
This means ‘FTSE 100 index’ contains the first company to 100th company and the ‘FTSE 250 index’ contains 101st company to 350th company.
When you invest in the FTSE 100 index fund, your profits would replicate those of the FTSE 100 index and the investment is made in the same companies. And similarly, when you invest in the FTSE 250 index fund your profits are in sync with those of the FTSE 250 index.
Another good example is the S&P 500 index fund which tracks the S&P 500 index that is comprised of the stocks of 500 large-scale companies of the United States. If you invest in this index fund, the profits would be like that of the benchmark index, i.e., the S&P 500 index as you are investing in the same companies.
Finally, it is noteworthy to talk about the Dow Jones Industrial Average (DJIA), which is the most popular benchmark index of the United States, especially related to blue-chip stocks.
This index tracks 30 large publicly owned companies, which are traded on the New York Stock Exchange (NYSE) and the NASDAQ. When you invest in an index fund that tracks the DJIA, then your fund would invest in the same 30 companies.
Before we get to know about hedge funds, we must know about long trades and short trades.
Long Trade – In a long trade, you would generally buy an asset and hold on to it and sell it when the price goes up. The financial terms ‘Buy’ and ‘Long’ are used interchangeably.
Short Trade – In a short trade, you would borrow a security and sell it and wait until the price goes lower than that. When the price decreases, you will buy that asset and make a profit from the difference. The financial terms ‘Sell’ and ‘Short’ are used interchangeably.
Hedge funds – Hedge funds were originally formed for holding both long and short stocks.
The positions are “hedged” (restricted) for reducing the risk, and therefore the investors earned profits regardless of whether the market had a surge or a fall.
The name became constant for referring to these types of investments and gained popularity enough to include all sorts of pooled investments.
These funds are suitable for wealthy individuals as they require higher fees, which include the fees paid to fund managers. Additionally, hedge funds come with a higher amount of risk compared to most other types of investments.
How they work – A fund manager raises capital from many investors and invests those pooled funds based on the agreed-upon investment strategy. There are different types of hedge funds, which are as follows.
- Hedge funds that specialize in ‘long-only’ equities, which means you could buy common stocks only and couldn’t sell short.
- Hedge funds that involve private equity, which means they purchase privately-held businesses entirely. By doing so, these funds typically take over the business operations, try to improve them, and sponsor for an initial public offering (IPO).
- Hedge funds that trade with junk bonds.
- Hedge funds that concentrate on real estate.
- Hedge funds that involve some specific asset classes like patents, copyrights, etc.
Example – For having a better understanding of the topic, let us have a look at a good example.
Let us say that you own a company named ‘Global Hygiene Products, LLC’, which is a company from a less popular region, and therefore, the costs involved with it for starting it are low. Moreover, the members of your company could choose to be anonymous.
According to the operating agreement that indicates the management process of the company, you would be receiving 25% of the profits over 5% each year.
You can invest in whichever asset you want such as stocks, bonds, mutual funds, etc., but the 5% mark is the milestone that should be achieved before the profits have been paid out.
Usually, the 5% hurdle and 25% share in the profits is just to mention an example, the general industry standard is 2% hurdle and 20% profit share.
Then an investor named ‘X’ decides to invest an amount of $200 million into your hedge fund. Usually, they do so by writing a check and you can cash it with a brokerage account and make use of the capital obtained.
You can use the money for whatever purpose you want such as expanding the company, buying another company, starting a new company, owning a local business, etc. You just have to make use of the money according to the guidelines in the operating agreement.
By taking the money from an investor, you must put it to work in such a way that you get the maximum possible returns while coping with the risk. The more profits you make for your investor, the more profits you get to keep for yourself.
Getting back, let us assume that you were able to make use of the capital in an efficient manner and made another $200 million on the invested $200 million within a period of one year.
Now, the first 5% (the hurdle rate), which is $10 million would be provided to the investor. Now, the remaining $190 million is split in a way such that you would get 25% and the investor would get $75%.
This means you receive $47.5 million, and the remaining $142.5 million would be offered to the investor. Including the hurdle, they receive profits of around $152.5 million.
Requirements – There is specific eligibility criteria regarding income and net worth for being able to invest in hedge funds. Only people or entities that are considered as ‘Accredited Investors’ are qualified for making an investment in hedge funds.
To most of you who may not be familiar with the term ‘Accredited Investor’, an accredited investor is an individual or an entity that qualifies for certain requirements of income and net worth.
In simple words, accredited investors are individuals who have a significant amount of net worth and income. By having so, they get access to a wide range of investment opportunities that normal people won’t have access to.
There are some advantages of being an accredited investor such as access to restricted investments, increased profits, and diversification at a huge level.
However, there are some drawbacks as well, such as the high amount of risk, significant amount of money necessary for meeting the minimum investment amount requirements, higher fees, volatility of the investments, etc.
Based on the country you are residing in, the requirements for being an accredited investor would vary.
However, let’s have an example of the requirements for a person to be able to invest in hedge funds.
- The income of an individual should be $200,000 or more per annum for a period of at least 2 consecutive years.
- If the income of a spouse is also taken into consideration, then the couple should have a joint income of $300,000 or more every year for a period of at least 2 consecutive years.
- In both cases discussed above, the investor should be able to prove that he or she has a strong reason to continue believing that they would receive this sort of income in the future as well.
- The minimum amount of net worth required is $1 million, which can be for a single individual or a married couple. This minimum requirement of $1 million should not include the primary residence of an individual.
- In the case of an entity, it should be having a trust with a net worth of at least $5 million, which should not be formed for making an investment, and it should be handled by a highly advanced investor.
- Any entity can invest in hedge funds when all the equity investors of that company/institution happen to be accredited investors (individually).
An Advanced Investor, also known as a Sophisticated Investor, should have all the necessary knowledge and experience for making the right decisions when there are a lot of risks involved with the respective investment.
People who manage hedge funds are paid based on the terms and conditions of their agreements in the funds they manage.
However, most of the hedge fund managers obtain an industry-standard rate of 2% and 20%, where 2% is a hurdle and 20% is profit share. Some other fund managers work based on profit sharing.
Government Bond Funds:
‘Government Bond Funds’ are nothing but the Fixed Income Funds/Bond Funds, which invest only in the assets that are backed by the respective country’s government.
Government bond funds come with lower risk and some examples include Treasury Bonds, Agency-Issued Debts, etc., which are backed by a country’s government.
The capital raised by the government with these funds can be used for its developmental activities and other operations such as infrastructure, road construction, employment opportunities, paying the already existing employees, etc.
Some other government funds:
The government creates some other types of funds as well, which are discussed below.
Debt-service funds – As the name itself suggests the purpose of these funds, the capital raised from these funds is used for repayment of its debts.
These debt-service funds are issued by the government for repaying either interest payments or the principal payments regarding a debt.
With the help of a debt-service fund, one might not have to worry about the risk involved with debt security as it gets reduced. Adding to that, the interest rate needed to sell the fund offering is also reduced, which makes them a good choice of investment for the investors.
Nevertheless, it connects a part of the invested money that has been received by the debt issuer, and by doing so, the capital cannot be used for any other profitable investments.
Capital project funds – It is the fund used to finance the resources related to capital projects of the government such as purchasing, construction, renovation, infrastructure, etc.
The money invested in these funds is held by the respective government which acts as a trustee.
Permanent funds – A permanent fund is utilized for collecting capital from investors and the pooled funds used for investment purposes by the government. However, the principal amount should not be used by the government, while it can make use of the profits obtained from it.
For example, let us have a brief yet detailed look at ‘Alaska Permanent Fund’. This fund is an investment fund, where the capital for the investment is obtained from the excess revenue acquired from gas and oil reserves in Alaska.
This fund is managed by the Alaskan Permanent Fund Corporation, which happens to be a corporation owned by the state. By the end of the year 2020, the value of this fund was more than $65 billion.
This fund pays annual dividends to the people residing in Alaska, who meet certain requirements, i.e., having a residence period of one year or more (criminals are excluded).
This fund invests the capital in various assets such as stocks, bonds, real estate, private equity, etc.
This fund disburses dividends on a continual basis until the person ceases to exist or the source of funding has been stopped permanently.
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