Mutual funds pool investors money to buy stocks and/or bonds. When an investor sends a mutual fund money, the fund issues the investor shares in itself and then buys stocks and/or bonds. When the investor wants his money back, the fund buys back its shares from the investor with the proceeds from selling the securities from its portfolio.
There is a mutual fund for every flavor: small cap, mid cap, large cap, value, growth, aggressive growth, income, emerging markets… There are now more mutual funds than the stocks they invest in.
Investors like mutual funds because of instant diversification, liquidity, and professional management. Wall Street likes them because they can charge a management fee based on assets under management.
Index Funds
Historically, few actively managed mutual funds outperform the market. This triggered the proliferation of index funds. Instead of coming up with an investment objective and a manager, these funds hold a basket of stocks that mirror an unmanaged index – like S&P 500.
Annuities
An annuity is a contract between an individual and an insurance company whereby the insurance company guarantees the annuity owner a stream of income in exchange for a lump sum. The income stream starts when the contract is annuitized. In most instances, the annuitizing is deferred, giving the individual time to make additional purchases and/or have the principal grow. The money in an annuity can be invested in mutual funds or the insurance company’s general account at fixed interest, in which case the insurance company typically invests it in real estate, bonds, and other financial instruments.
Investors like annuities because of the tax deferral and an attractive array of settlement options. Insurance companies like annuities because they can charge an arm and a leg for all the bells and whistles and guarantees they provide.
ETFs – Exchange Traded Funds
Unlike mutual funds, ETFs trade on an exchange just like stocks. When an investor buys or sells shares in an ETF, the ETF in turn does the same with an unmanaged basket of stocks based on an index or industry group. ETFs are popular because they are cheaper than mutual funds, can be traded throughout the day, and provide instant access to a basket of stocks in a particular sector – like semiconductors or oils.
There are now 2x and 3x ETFs, inverse ETFs, and ETFs that invest in commodity futures. 2x and 3x ETFs use leverage to magnify the underlying stock moves. For example, a 10% move in the S&P 500 translates into a 30% move in a 3x ETF that is based on the index. An inverse ETF moves in the direction opposite to the underlying index, i.e. it lets you bet on stocks’ decline. If the S&P drops 10%, an inverse ETF will rise 10%. Inverse ETFs can also use leverage. Commodity ETFs can invest in oil, currencies, or representative baskets of commodities.
CEFs – Closed-End Funds
A CEF is a cross between an ETF and a mutual fund. Like an ETF, a CEF’s shares trade on an exchange. Like a mutual fund, a CEF is actively managed based on a stated objective.
Unlike a mutual fund that constantly issues and redeems its shares, the number of shares in a CEF is fixed. If an investor wants out, he sells his shares to somebody else – just like any other stock. This way, the amount of capital a CEF has under management remains constant. This prevents a situation when multiple redemption requests force mutual funds to sell underlying holdings at whatever prices they can get, often depressing share prices and hurting existing shareholders.