Investment Vehicles 101: A Beginner's Overview

Investment vehicles are the tools you use to invest in assets, such as stocks, bonds, and real estate.

A key consideration is the level of risk you're willing to take on, with some vehicles offering higher potential returns but also greater risk.

Low-risk investment vehicles include high-yield savings accounts and certificates of deposit (CDs), which typically earn around 2% interest.

These vehicles are great for short-term savings goals or emergency funds.

Stocks, on the other hand, are considered a higher-risk investment, as their value can fluctuate rapidly.

Investment vehicles come in various forms, including stocks, bonds, mutual funds, real estate, commodities, and more. Stocks represent ownership in a company and offer potential high returns, but are considered riskier compared to other assets.

Bonds are fixed-income securities where investors loan money to governments or corporations in exchange for regular interest payments. They provide a relatively lower return but are considered less volatile.

Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. They offer individuals the opportunity to access a professionally managed portfolio without the need for extensive knowledge or time commitment.

Investors can also consider Exchange-Traded Funds (ETFs), which are similar to mutual funds but trade on stock exchanges like individual stocks. They provide diversification, liquidity, and low expense ratios.

Real Estate Investment trusts (REITs) are investment vehicles that own and manage income-generating real estate properties. They provide dividends and diversification, making them an attractive option for investors.

Certificates of Deposit (CDs) are time deposits offered by banks, providing a low-risk option for short-term savings goals.

Securities are a type of investment vehicle that represents ownership in a company. Stocks, for example, represent ownership in a company and give investors the potential to benefit from the company's growth and profitability.

Bonds, on the other hand, are debt securities issued by governments, corporations, or municipalities, where investors essentially lend money to the issuer in exchange for periodic interest payments and the return of the principal at maturity.

Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets, offering individuals the opportunity to access a professionally managed portfolio without extensive knowledge or time commitment.

ETFs, or exchange-traded funds, are similar to mutual funds but trade on stock exchanges like individual stocks, providing diversification, liquidity, and low expense ratios.

REITs, or real estate investment trusts, invest in income-generating real estate properties, such as office buildings, malls, and apartments, and distribute most of their profits as dividends.

Securities can be public or private, and investors should consider factors like risk tolerance, investment horizon, and financial goals when choosing the best investment vehicle for their needs.

Direct investments are specific asset class holdings or securities that generate an investment return. Examples of direct investments include stocks, bonds, or rental real estate.

You have complete control over which assets or securities to purchase, unlike indirect investments where a professional portfolio management team selects the investments for you.

Direct investments can include both public and private assets, giving you a wide range of options to choose from.

Here are some key characteristics of direct investments:

Pooled investment vehicles are a type of indirect investment that allows multiple investors to pool their money together to gain certain advantages. This is a common strategy among individual investors who may not have the expertise or resources to make informed investment decisions on their own.

Sponsored by companies like Vanguard and iShares, pooled investment vehicles are created and led by a sponsor who hires a portfolio management team to select direct investments. Shareholders own the vehicle itself, rather than the underlying direct investments.

Examples of pooled investment vehicles include open-end mutual funds, closed-end funds, and exchange-traded funds (ETFs). These vehicles offer a convenient way for investors to diversify their portfolios and gain exposure to a wide range of assets.

In a mutual fund, a professional fund manager chooses the type of stocks, bonds, and other assets that should compose the client's portfolio. This service comes with a fee, which can be a drawback for some investors.

Here are some common types of pooled investment vehicles:

Pooled investment vehicles can provide a range of benefits, including lower costs, greater diversification, and access to professional management. However, they also come with their own set of risks and challenges, which investors should carefully consider before investing.

Angel investors are wealthy individuals who invest in startups in exchange for equity, often taking a hands-on role in the operations of the business.

Venture capital firms pool their money to invest in high-growth, high-risk companies, providing capital at all stages of development and often offering mentoring and advice.

Crowdfunding allows startups to raise money by appealing to a large number of small investors, typically used by companies with innovative ideas but limited resources.

Private equity funds invest in companies in exchange for ownership equity, often used by larger companies or those with established businesses looking for additional capital.

Debt financing is an option for companies that don't want to give up ownership equity, allowing them to borrow money from banks or other financial institutions and pay it back with interest over time.

Direct investments, such as stocks, bonds, or rental real estate, allow investors to have complete control over their investments and avoid professional portfolio management fees.

Here are some key characteristics of direct investments:

Investing in high-yield investment options can be a great way to grow your wealth over time. High-yield investments typically offer returns that are significantly higher than traditional savings accounts or low-risk investments.

Certificates of Deposit (CDs) are a type of high-yield investment that can provide a fixed return over a set period of time, often with a higher interest rate than a traditional savings account. The interest rate on a CD can vary depending on the term length, with longer terms typically offering higher rates.

High-yield savings accounts are another option for those who want to earn a higher return on their savings without taking on too much risk. These accounts often come with some restrictions, such as limited transactions per month, to qualify for the higher interest rate.

Some high-yield investments, like bonds, offer a higher return in exchange for taking on more risk. Bonds are essentially loans to a borrower, and the borrower agrees to pay back the loan with interest. The interest rate on a bond can vary depending on the creditworthiness of the borrower and the market conditions at the time of purchase.

Venture capital is a popular investment option for startups, providing high-risk, high-potential funding in exchange for equity or a stake in the company.

Venture capital firms often provide capital at all stages of a company's development, from seed and early stage investments to later stage investments.

Angel investors can be beneficial for startups, offering not only capital but also mentorship and guidance to help entrepreneurs navigate the startup process.

Angel investors typically have a high risk tolerance and take a hands-on role in the operations of the business.

Crowdfunding is a way for startups to raise money by appealing to a large number of small investors, often used by companies with innovative ideas but lacking traditional investors.

Private equity funds invest in companies in exchange for ownership equity, typically investing later in a company's development when it's already generating revenue or has raised other forms of financing.

Loans can be taken out from banks or other financial institutions, providing short-term financing without giving up ownership equity, but often come with higher interest rates.

Venture capital is often the most expensive type of investment, but it can provide the necessary capital for high-potential startups.

Crowdfunding can be a great option for startups who don't have the resources or connections to secure traditional forms of financing.

Debt financing is an option for companies that want to avoid giving up ownership equity, but it typically has higher interest rates than traditional loans.

Direct vs Indirect investments are two distinct ways to invest your money. Direct investments are owned directly by the investor.

Investors who choose direct investments often have more control over their investments, but they also pay higher fees to professional portfolio managers.

A portfolio manager selects the investments for direct investments, which can be a benefit for those who don't have the time or expertise to make investment decisions themselves.

Investors who opt for indirect investments, on the other hand, pay a management fee to a portfolio manager to choose and monitor direct investments.

Indirect investments can be found in various forms, including ETFs, mutual funds, and hedge funds.

Here's a comparison of direct and indirect investments:

ETFs, mutual funds, and hedge funds

Both direct and indirect investments can be public or private, offering a range of options for investors to choose from.

Portfolio management is a crucial aspect of investing, helping you make informed decisions about your money.

A well-diversified portfolio can provide a stable source of income, as seen in the case of bonds, which offer regular interest payments.

By spreading your investments across different asset classes, you can reduce your risk and increase potential returns.

For example, a portfolio with a mix of stocks and bonds can provide a balance between growth and stability.

Regular portfolio rebalancing is essential to maintain this balance and keep your investments aligned with your goals.

This can be done by selling or buying assets as needed to maintain your target asset allocation.

A study found that regular rebalancing can lead to higher returns and lower risk over the long term.

By monitoring your portfolio regularly, you can make adjustments as needed to stay on track and achieve your financial goals.

Investment risks come in various forms, including market risk, credit risk, inflation risk, liquidity risk, and reinvestment risk. These risks can significantly impact investment performance.

Market risk refers to the possibility of losing money due to fluctuations in overall market conditions. Factors such as economic events, political instability, interest rates, and investor sentiment can significantly impact market performance.

To mitigate these risks, it's essential to understand the different types of investment returns, including capital gains, dividend income, interest income, and rental income. These returns can help offset potential losses.

Here are some common types of investment risks and returns:

Understanding these risks and returns can help you make informed investment decisions and maximize your returns.

Market risk is a possibility of losing money due to fluctuations in overall market conditions. Economic events, political instability, interest rates, and investor sentiment can significantly impact market performance.

Credit risk arises from the possibility of a borrower defaulting on their debt obligations, which is particularly relevant when investing in fixed-income securities such as bonds or lending platforms.

Inflation risk refers to the erosion of purchasing power over time due to rising prices, which can erode the returns on investments, especially those that do not keep pace with inflation.

Liquidity risk arises when an investor is unable to buy or sell an investment quickly at a fair price, posing higher risks for illiquid investments such as certain real estate assets or private equity.

Risk measures how much an investor could potentially lose if the investment falls short of the expected return, and it's also measured by volatility, which reflects how much the investment deviates from the expected return.

A more volatile investment will have wider performance swings compared with a less volatile investment, which means volatile investments can suffer greater losses than investments with lower volatility.

The worst-case historical or expected loss for an investment vehicle is known as its maximum drawdown, which can be a significant factor in determining an investment's risk level.

Investors should be aware that a less volatile investment will see most of its annual returns congregate around the expected return, while a volatile investment will see more returns well above or well below the expected return.

Expected returns are a realistic assumption of how much an investor could earn holding an investment over an intermediate-to-longer-term period.

The expected return is primarily driven by direct investments, which are those held by the investor directly or within an indirect investment vehicle such as a mutual fund.

For most investments, the expected return is a function of three components: the investment's cash flow in the form of dividends, interest, or rents; how much the cash flow is expected to grow over time; and what investors are paying for the cash flow now versus in the future.

These three components are crucial in estimating the expected return of stocks, bonds, and other asset classes, as discussed in Chapter Three of "Money For the Rest of Us: 10 Questions to Master Successful Investing".

A good understanding of expected returns can help investors make informed decisions and manage their investment risks.

Investors can use the following formula to estimate the expected return of an investment:

Expected Return = (Cash Flow x Growth Rate) / Current Price

This formula takes into account the investment's cash flow, growth rate, and current price to provide a realistic estimate of the expected return.

Here's an example of how to use this formula:

Suppose an investor buys a stock with a current price of $100 and a cash flow of $5 per share. If the growth rate is 10% per year, the expected return would be:

Expected Return = ($5 x 1.10) / $100 = 5.5%

This means that the investor can expect to earn a return of 5.5% per year on their investment.

By understanding expected returns, investors can make more informed decisions and manage their investment risks more effectively.

Co-investment has become a saturated market, and the quality of co-investors varies widely. This has led to concerns about the fairness and transparency of co-investment opportunities.

The majority of co-investors are "passive" rather than leading or underwriting deals, which has caught the attention of the SEC. They are reviewing and considering new regulations to address these differences.

GPs may over-allocate co-investment opportunities to potential future fund investors, leading to "sweet deals" and an unfair advantage. This can create conflicts of interest within the fund structure.

Co-investment can also lead to conflicts of interest when co-investors dilute the stakes of major fund investors. This can create tension and potential disputes within the fund.

Investment platforms are crucial for connecting buyers and sellers of investment vehicles, allowing individual investors to access public investment vehicles like stocks and ETFs through firms like Vanguard, Fidelity, and Schwab.

Crowdfunding platforms, such as Fundrise or OurCrowd, provide access to private investment vehicles, including private indirect investment funds or direct investments in individual start-ups.

Investment vehicles have a structure that affects how they're organized and accessed by investors, including whether they're direct, indirect, public, or private, and their liquidity terms, costs, and use of leverage.

An investment vehicle's structure can also impact its tax implications and may have an account minimum, making it essential for investors to study the offering documents closely, such as a prospectus for public vehicles and an offering memorandum for private vehicles.

Platforms provide access to various investment vehicles, and they come in different forms.

A brokerage firm connects buyers and sellers of public investment vehicles like stocks and ETFs, offering access to investors through firms like Vanguard, Fidelity, and Schwab.

Crowdfunding platforms, on the other hand, connect investors with private investment opportunities, including private indirect investment funds and direct investments in individual start-ups, as seen with Fundrise or OurCrowd.

Liquidity is a crucial aspect of investment vehicles, and it's essential to understand how quickly and easily you can sell an investment to get cash. An investment is more liquid if there's a large pool of willing buyers and sellers.

Public investment vehicles are typically more liquid than private investment vehicles because they have more buyers and sellers and a centralized place to transact. This is because public investments are often traded on established markets.

The liquidity of an investment can have a significant impact on its price. Illiquid investments have fewer buyers and sellers, which can result in a lower price when you try to sell. This is because sellers may have to accept a lower price to attract a buyer.

Less liquid private investment vehicles often offer higher expected returns to compensate investors for the illiquidity. This extra return is called an illiquidity premium.

Structured investments offer a range of options for investors, with various sponsors and conduits involved. ABN AMRO, for example, sponsors Amstel Funding, a conduit for structured investments.

AIG sponsors Nightingale Finance, another conduit for structured investments. Axon Asset Management sponsors Axon Financial Funding, a conduit with its own unique characteristics.

Structured investments can also be sponsored by banks, such as Bank of Montreal, which sponsors Links Finance and Parkland Finance. Barclays, on the other hand, sponsors Sheffield Receivables.

Here is a list of some of the structured investment vehicles mentioned in the article:

Investment costs are a crucial aspect to consider when evaluating an investment vehicle. Direct investments have the lowest cost because there is no sponsor involved in selecting investments.

Investors should be aware that indirect private investment vehicles, such as hedge funds and venture capital partnerships, have the highest costs due to complex underlying investments and high asset management fees.

Public, indirect investment vehicles, like index mutual funds and ETFs, have the lowest costs because they require less day-to-day research and trading, making them more tax-efficient. Index funds and ETFs also have lower costs due to their ability to replicate a specific market benchmark.

Here are some key differences in costs between investment vehicles:

Investment pricing is also an important consideration. Some investment vehicles, like stocks and ETFs, have market prices set by trades on an exchange in the secondary market. Others, like open-end mutual funds, have prices set by the sponsor based on the value of the underlying holdings.

Costs can be a significant factor in investment decisions. Direct investments have the lowest cost because there is no sponsor involved in selecting investments.

Indirect private investment vehicles, such as hedge funds and venture capital partnerships, come with high costs due to the complexity of underlying investments and the need for day-to-day oversight by the portfolio management team.

Public, indirect investment vehicles like index mutual funds and ETFs have lower costs because managing these investment vehicles requires less research and trading. They are also more tax-efficient due to fewer sales of underlying holdings.

Actively managed open-end mutual funds and closed-end funds have higher costs due to the additional work in selecting direct investments and higher trading costs.

Pricing is a crucial aspect of investment vehicles. The market price is set in different ways, depending on the type of investment.

Some investment vehicles, like stocks, ETFs, and closed-end funds, have their market prices determined by trades on an exchange in the secondary market. This can result in prices that differ from the net value.

The price of indirect investment vehicles like open-end mutual funds is set by the sponsor based on the value of the underlying holdings. The fund sponsor determines the net asset value (NAV) per share by calculating the market price of the assets, subtracting liabilities, and dividing by the number of shares outstanding.

Mutual fund sponsors set the market price per share equal to the NAV, and create and redeem shares at the market price. This process helps keep the price in line with the underlying value.

ETF sponsors work with authorized participants to try to keep the ETF price close to the net asset value, but it's not always possible. Closed-end funds, on the other hand, don't have a mechanism to narrow the discount or premium to the net asset value.

Here are some key points to consider when evaluating the pricing of an investment vehicle: