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The 1,400 or so ETFs available cover a wide variety of market segments; you can invest in anything from agriculture to European stocks to bonds to physical gold to certain baskets of commodities priced in Australian dollars. Most ETFs own individual stocks, but some may own physical commodities or futures contracts for those commodities. ETFs can be grouped into General Equity (like the “SPDR” mentioned at the outset), International Equity, Dividend, Fixed-Income (mostly bonds), Commodity, Strategy (for example, low-volatility investments or companies that buy back their own shares), and Sector (companies in certain industries, like auto manufacturing).
Most ETFs are tied to specially created indexes; that is, rather than being actively managed by a fund manager (a professional human), they are simply modeled after a pre-existing index, like the S&P 500 indexes mentioned in the SPDR example. Financial firms have created indexes for almost anything; the index determines what investments are owned, and in what proportion. The ETF manager simply buys and sells securities in the open market to track the index. There are more than a dozen financial services firms offering ETFs to the public; the three largest and best known are BlackRock (branded “iShares”), Invesco (“PowerShares”), and State Street Global Advisors (“SPDRs,” now an entire family of funds).
ETFs offer several advantages to investors:
Low cost. Fees and expenses are typically half of traditional mutual funds.
Convenience. It’s easy to buy, sell, and rotate these funds during the day, and to own as many or as few as you want at any time. ETFs cover wide or narrow swaths of the market, making it easy to participate, say, in the economies of Eastern Europe, without becoming an expert or trading those securities directly.
Transparency. It’s easy to see and track what they own—that is, what you own.
Why You Should Care
ETFs are easy for individual investors, and offer a low-cost way to participate in the segments of the market best for you. They’re easy to use and an excellent and relatively safe way to diversify. For the economy as a whole, they provide a low-cost and lower-risk opportunity for many more investors to invest and participate. Availability and use of ETFs in employer retirement plans (like 401(k)s) is growing, so you’re more likely to run across them as investment choices if you haven’t already. But because it is so easy to rotate, they can cause faster swings in the markets and between different sectors of the market—in short and to a degree, ETFs “speed” change in the markets.
72. HEDGE FUND
Suppose you’re fortunate to have a great deal of “investable wealth.” A million or more, tens of millions, even better. You aren’t content to just perform with the market. And picking individual stocks and managing your own investments just isn’t your thing. You want to be “in” with the big boys, scoring way better than average returns. You want 10, 15, or 20 percent or more, rather than the 5 percent everyone else is settling for. You want to invest the way other rich, famous, and privileged people do. A hedge fund might be your answer.
What You Should Know
As it turns out, hedge funds are the privileged-class answer to the ordinary mutual fund. In the interest of not meddling too much in the world of private wealth and capital, the 1940 act has two commonly used exemptions excluding certain types of funds from close regulation. These exemptions gave rise to what are now known as “hedge funds.” As a result, hedge fund governance is limited primarily to two areas: who can invest and how they’re sold. The early hedge funds did what the name suggests—they helped investors “hedge” against market downturns or other unforeseen events, because rules and predominant investing strategies made it difficult for ordinary funds or individual investors to do so.
There are two types of funds that exist under these relatively light rules. One type of fund is limited to 100 or fewer investors, and can only be marketed to investors with more than $1 million in investable assets, or verifiable income exceeding $200,000 a year. The other can have an unlimited number of investors, but each must have $5 million of investable assets. The first type doesn’t have to be registered with the SEC at all, the second only if it has more than 499 investors. Furthermore, there’s no requirement for the managers of either type of fund to be registered or otherwise qualified or credentialed with the SEC, or with any other regulatory body or trade organization. For most of their existence, the rules stated that neither type of fund could be “offered or advertised to the general public,” but that rule was overturned in mid-2013 by the SEC, and advertisements will be permitted going forward.
As a result, hedge funds are largely left to do what they want, and the managers can charge some pretty hefty fees for their services. Common was the “2 and 20” compensation rule, where the manager is guaranteed a fee of 2 percent of the fund’s net asset value plus 20 percent of the investment gains over a specified amount. That’s a pretty powerful incentive.
Without close regulation, hedge funds are allowed to sell short, borrow money, and invest in “derivative” instruments like futures and options to enhance returns. Effectively, they can leverage their portfolio, controlling, say, $10 million in assets with, say, $2 to $5 million in equity. That’s great when things are good, not so great when things go bad. Bottom line: hedge funds allow wealthy investors to chase high returns using exclusive private investments administered by managers with few boundaries, who tend to chase the highest returns possible to get the biggest fees. It’s a potent combination for success, but also for failure.
Why You Should Care
Despite some of the horrendous losses incurred by some hedge funds in the Great Recession, not all hedge funds are bad, and they do bring a lot of capital to market from the coffers of the wealthy. However, their power and numbers, some 10,000 funds managing some $2.5 trillion in assets, can cause some pretty outsized market moves and distortions, such as the oil price run-up in mid-2008. When markets do well, most hedge funds do well—and vice versa. When things start turning south for hedge funds, because of leverage they’re often forced to dump conservative investments, a factor that probably amplified the 2008–2009 stock and commodity market collapse.
Legislative attempts have been made to regulate hedge funds, and the 2010 Dodd-Frank Act (see #39) started to require managers of larger hedge funds with more than $150 million in assets and/or more than fifteen clients to be registered as Registered Investment Advisers, but not much else has happened in terms of regulatory oversight; hedge funds are still mainly in the “Wild West” corner of the investment markets.
73. PRIVATE EQUITY
Private equity is a general term for equity, or stock investments in businesses not traded on a stock exchange. Private equity is an important source of investment capital for distressed firms or brand-new companies, because they don’t have to go through the rigors of public listing, accountability, and disclosure. Venture capital, investments made in new business ventures, is one form of private equity.
What You Should Know
Private equity companies can be firms or funds that typically get their money to invest from large institutional investors or very wealthy individuals, and in turn make investments in or acquire companies outright. Private equity firms may acquire already existing “public” companies or the majority of a company through leveraged buyouts (see #74), and usually use venture capital to take a smaller stake in order to minimize their risk.