No Nonsense Guide To Finance #3

Those pesky financial advisers will often throw around terminology that they perceive to be universally understood, when in actual fact, the words they use can be quite industry-specific and not as familiar to the client as the adviser may assume.

You know I like to keep things as simple and as no-nonsense as possible, so here are six commonly-used terms broken down for you.

This time we’re looking at:

  • Money Market
  • Mutual Funds
  • Bonds
  • ETFs
  • REITs
  • Hedge Funds

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What is the Money Market?

A financial adviser may talk about allocating a certain amount of your investment to the ‘Money Market’, but what exactly is that?

The money market is one of several parts of the financial market. It is used as a kind of wholesale market where banks, governments and other entities can lend to and borrow from each other on a short-term basis – and that could range from overnight to just under a year.

The money market provides a wide range of investment opportunities and funding possibilities and some of the cash instruments traded include:

  • Certificates of Deposit
  • Time Deposits
  • Treasury bills
  • Commercial paper
  • Bankers’ acceptances

I won’t go into the specifics of each on here, but they can be accessed by retail investors via a money market fund.

Using this kind of fund makes sense if you to park you money somewhere other than in equities or bonds for a while, but want to remain liquid enough to move into something else quickly should the need arise.

You won’t earn than much interest, but it will generally be more than you would receive from a regular bank deposit account.

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What is a Mutual Fund?

This is a type of investment vehicle made up of money pooled by investors in order to buy stocks, bonds, money market instruments and other assets. The equivalent in the UK is known as a Unit Trust.

These funds use a professional manager or team of managers, who allocate the money in line with the fund’s objective in order to produce gains for the investors.

Mutual funds give retail investors an opportunity to ‘chip in’ together and participate in professionally-managed portfolios that might otherwise be too expensive access on an individual basis.

A mutual fund might hold anywhere between a dozen and over a hundred different securities, which provides diversification at a much lower cost than if they had to trade each fund individually.

There are all kinds of different mutual funds that enable access to equities (stocks), fixed income (bonds) and money market instruments (see above) and each of these can provide exposure that is either very broad (e.g. a global equity fund) or regional or sector-specific (e.g. an Emerging Market Bond fund or a Bio-technology fund)

The main advantages of mutual funds are diversification, economies of scale and easy access to a professionally-managed investment portfolio.

Some disadvantages are that they can be quite expensive to run, the managers often don’t bring enough value to justify the fees and they can be too diversified.

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What is a Bond?

Simply put, a bond is a type of loan, in which the investor lends money to the issuer of the bond over a fixed period of time in return for interest (known as a coupon) at a pre-determined rate.

Bonds are also known as fixed-income or fixed-interest securities and are one of the major assets classes, along with equities (stocks) and the money market.

As mentioned above, there are mutual funds (and ETFs, see below) that hold different types of bonds and these are great for investors that don’t want to have to purchase individual bonds, but still want a fixed-income element to their portfolio.

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What is an ETF?

Exchange-Traded Funds (ETFs) came about in the early 1990s and are a type of security that track a ‘basket’ of stocks, bonds or commodities or an index. They can be bought and sold on the stock exchange, just like a regular stock.

ETFs are similar to mutual funds in many ways, but there are a few distinguishing features that might make them more attractive to many investors.

Firstly, the investment minimums are much lower than those required for mutual funds, which makes them more accessible.

Secondly, while not true in all cases, the vast majority of ETFs are passively-managed, which results in much lower operating expenses than mutual funds. This can reduce performance drag and so most ETFs tend to outperform their mutual fund equivalents.

Another advantage is that, due to the way in which securities within the ETF are bought and sold, they are a lot more tax efficient than mutual funds.

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What is a REIT?

REIT stands for Real Estate Investment Trust, which is a bit like a mutual funds that owns income-producing property, rather than stocks and bonds.

REITs can provide investors with great diversification via exposure to the commercial real estate market, without having to buy the physical bricks and mortar.

Typically, REITs hold assets such as large commercial, apartment and retail buildings, but you may also see some that own hotels, care homes and the like.

You can also find ‘mortgage’ REITs that own the debt on the properties, rather than actual the property itself.

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What is a Hedge Fund?

At its simplest level, a hedge fund is a privately-run investment company that uses a number of different investment strategies to generate returns for their investors.

Hedge funds are generally only accessible to accredited investors and are not regulated in the same way as other securities, which can make them much more risky.

The aim of a hedge fund is usually to produce consistent returns, regardless of what the market is doing, hence the use of the word ‘hedge’, as in, ‘hedging’ your bets.

The methods used to do this are not often very transparent, since they may use their own proprietary systems that they do not wish to fall into the public domain.

Whilst there are hedge funds that have produced some really good, consistent returns, they can also result in spectacular losses, since they are often leveraged and the managers aren’t always as smart as they think they are.

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