What are funds?
Individual investors and small institutions who invest with a diversified strategy usually do it through funds. A fund is simply a pool of money invested in a portfolio of stocks, bonds, money market instruments and/or other assets, managed by one or more professionals who follow a stated investment objective. This means that when you buy shares from a fund, you are allocating your money in a lot of assets at the same time, a little bit in each one. That provides diversification at a very decent cost, because only one trade is performed and the fees charged by fund companies, to pay for the managers and all the trouble, are modest if the funds are well chosen.
Some people say that an important advantage of investing through funds is that you gain access to professional portfolio management. Actually, the stock-picking ability of these managers is not what interests us most, because of the aforementioned hypothesis about stock picking being useless. What we like most about funds is the possibility to diversify our portfolios at low cost.
Kinds of funds
In the world of investments in securities, there are basically three kinds of funds: mutual funds, closed-end funds (CEFs) and exchange-traded funds (ETFs). Mutual funds are the classic flavor: a product from a financial company that sells you shares (this is, a percentage of the pool's value) and invests the receipts according to the stated objective, forming a portfolio that is routinely published. The shares regularly distribute dividends, which you can have reinvested in the fund automatically if you order so, and you can sell the shares back to the issuing company at any time.
Mutual funds are bought from and sold to the issuing company, although many financial institutions act as intermediaries and are thus able to market mutual funds from companies they have agreements with. The main difference with closed-end and exchange-traded funds is that those other kinds are traded in stock exchanges just as any other ordinary share of stock. Therefore, to operate with CEFs and ETFs, you just need an ordinary account with a stock broker.
The difference between mutual and exchange-traded funds has implications that may incline you to build your portfolio either with mutual funds alone or by combining CEFs and ETFs. Furthermore, CEFs and ETFs have special characteristics because of their implementation mechanisms. In future articles, we will discuss the differences between mutual funds, CEFs and ETFs in more detail, so that you can select the vehicles that better suit you.