An investment company can be a corporation, partnership, business trust or limited liability company (LLC) that pools money from investors on a collective basis. The money pooled is invested, and the investors share any profits and losses incurred by the company according to each investor’s interest in the company. Investment companies are categorized into three types: closed-end-funds, mutual funds (or open-end funds) and unit investment trusts (UITs). Each of these three investment companies are registered with and regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940.
Mutual funds are a popular way to diversify an investment
portfolio without buying individual stocks,bonds, and other securities. Funds
that issue an unlimited number of shared based on investor demand are called
open-end-funds, while close-end-funds issue a fixed number of shares at an
initial public offering (IPO). Both funds pool investor money to invest in a
diversified portfolio of assets, and both are usually actively managed. The
third category of investment company, the Unit Investment Trust also issue
redeemable shares. They have a fixed portfolio of securities and a specific
termination date.
How Open-End-Funds Work
Open-end-funds most often come in the form of mutual funds.
These types of mutual funds have an unlimited number of shares to sell directly
to investors, excluding the need for an exchange. Open-end mutual funds can
only be bought and sold at the end of each trading day, at their net asset
value (NAV). The NAV is calculated at the end of the trading day by multiplying
the number of shares of each fund-owned stock and bond by their closing price.
Any liabilities of the fund are subtracted, and that total is divided by the
number of outstanding shares. The result is the NAV, which becomes the fund’s
price per share.
When investors sell their shares back to the company, the
shares are taken out of circulation. If a large number of shares are sold
(called redemption), the fund may have to sell some of its investments in order
to pay the investors. The funds do not trade on the open market. Their shares can
only be sold back to the company that issued them.
Closed-End Funds
A closed-end-fund is launched through an initial public
offering (IPO) in order to raise money for investment. The funds then trade in
the open market just like a stock or an ETF. Only a set number of shares are
issued. But since the shares continue to trade, their market price is affected
by supply and demand. That means the shares may trade at a price above or below
their net asset value (NAV), the price at which it was issued. The purpose of
these funds is to pay distributions to their investors, which may include
earnings, capital gains, and return of principal. Nearly 70% of closed-end
funds use leverage to potentially boost returns.
Unit Investment Trusts (UITs)
A unit investment trust (UIT) is an investment company that
offers a fixed portfolio, generally of stocks and bonds, as redeemable units to
investors for a specific period of time. UITs are designed to provide capital
appreciation and/or dividend income.
Like open-ended mutual funds, UITs offer professional
portfolio selection and have a definitive investment objective. They are bought
and sold directly from the issuing investment company, just as open-ended funds
can be bought and sold directly through fund companies. In some instances, UITs can also be sold in
the secondary market. Like closed-end
funds, UITs are issued via an initial public offering (IPO)
Unlike either mutual funds or close-end funds, a UIT has a
stated date for termination. This date is often based on the investment held in
its portfolio. For example, a portfolio that holds bonds may have a bond ladder
consisting of five-, 10-, and 20-year bonds. The portfolio would be set to
terminate when the 20-year bonds reach maturity. At termination, investors receive their
proportionate share of the UITs net assets.
While the portfolio is constructed by professional
investment managers, it is not actively traded. After creation, it remains
intact until dissolution, and securities are sold or purchased only in response
to changes in the underlying investments (such as corporate mergers or
bankruptcies).
In summary, a unit investment trust (UIT) issues a set
number of units that represent undivided interest in a specific, fixed
portfolio of securities. They have a specific termination date, and investors
receive a pro-rata share of the UIT’s net asset upon termination. UITs are
passive investments in that they typically invest in a fixed portfolio of
securities, such as stocks or bonds, and are not actively traded or rebalanced
like the portfolios of mutual funds or closed-end-funds. UITs may charge fees,
including a creation and development fee, a trustee fee, and other expenses,
which can reduce returns.
Financial Risks to Consider When Investing in an Investment Fund
Investing in investment funds involves a variety of
financial risks that investors should be aware of.
Market risk
Market risk is the potential for the entire market to move
in a direction that affects all investments, not just a particular fund. Market risk can lead to fluctuations in the
fund's value. When markets decline, the fund's NAV (Net Asset Value) may
decrease.
Specific risk
Specific risk refers to the risk associated with individual
investments within the fund. Also called unsystematic risk, it pertains to
individual securities within the fund. Factors include company-specific events,
management decisions, and industry trends. Specific risk affects specific
holdings. For example, poor performance of a single stock can impact the fund's
overall returns, which can be mitigated through diversification.
Liquidity risk
Liquidity risk is the
risk that investors may not be able to buy or sell shares quickly enough to
prevent or minimize a loss. Liquidity risk arises when it's difficult to buy or
sell fund shares due to low trading volume or market conditions. Illiquid funds
may face challenges during market downturns or when investors rush to redeem
shares
Credit risk
Credit risk involves the possibility that a bond issuer
could default on a payment, affecting the value of fixed-income investments
within the fund. If the fund holds bonds
with credit risk, it may experience losses if issuers default.
Interest rate risk
Interest rate risk is
the risk that changes in interest rates will negatively affect the value of the
fund's investments, particularly bonds. Interest rate risk occurs when bond
prices move inversely to interest rate changes. Rising interest rates can lead
to bond price declines, affecting the fund's NAV.
Currency risk
Currency risk applies to international funds and is the risk
of loss from fluctuating exchange rates. Currency risk arises when investing in
foreign securities. Exchange rate fluctuations impact returns.
Manager risk
Manager risk is the risk that comes from the fund manager's
decision-making, which could lead to underperformance. Poor investment choices or changes in
management can affect performance.
Redemption risk
Lastly, redemption risk arises when a large number of
investors withdraw their money from the fund at the same time, potentially
forcing the fund to sell assets at unfavorable prices, affecting remaining
investors.
Understanding these risks is crucial for investors to make
informed decisions and align their investment choices with their financial
goals and risk tolerance. 🌟
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