There are many varieties of funds out there, so it’s easy to get confused. We’ll explain some of the most common types of funds, how they work, and how they may impact individual investors. Find out what funds you need to achieve your money goals.
Definition and Examples of a Fund
A fund is a pool of money individuals, businesses, investment companies, or governments create for a designated purpose. Funds are common in daily life, and you may have established or contributed to a fund without even knowing it. Funds can be used for many different purposes. Let’s say a couple is preparing to have a child. When getting ready for parenthood, they may decide to start putting away and saving money for that child’s higher education. In this case, the soon-to-be parents are creating a fund to be used if and when their child is ready to go to college.
How a Fund Works
No matter what you are allocating money for, pooling money in a fund is one way to reach a goal or achieve a designated purpose. Below, find some common types of funds you may have or want to create as an individual:
Emergency fund: If you’ve set money aside in a separate bank account in case of an unexpected expense, you’ve established an emergency fund for yourself. Financial planners typically recommend having an emergency fund that can cover three to six months’ worth of expenses. Retirement fund: If you have a 401(k) or a similar employer-sponsored account, or you’ve set up an individual retirement account (IRA), you have a retirement fund. These accounts offer important tax advantages, although you’ll typically have to wait until you’re at least age 59 ½ to withdraw your money and avoid penalties. Education fund: Many parents start an education fund to pay for their child’s higher education. A popular option for doing so is a 529 plan, which comes in two forms: education savings accounts and prepaid tuition plans. Trust fund: A trust fund is an estate-planning tool in which a third party, known as the trustee, manages assets within the trust on behalf of a beneficiary. Trust funds are often used to avoid probate and in some cases, reduce estate taxes. Some people use trusts to control the distribution of their assets after they die, too.
Types of Investment Funds
Often, the word “fund” refers specifically to investment funds. Below, learn about the most common types of funds within the investment world, all of which pool the funds of investors in hopes of seeking greater returns.
Mutual Funds
A mutual fund is one of the most common types of investment funds. The fund pools many investors’ money and uses the total amount to invest in a mix of securities, which provides instant portfolio diversification. Some mutual funds are passively managed index funds, which means they attempt to mirror the performance of a benchmark index, like the S&P 500. However, many mutual funds are actively managed, which means the fund manager tries to outperform an index by using strategies like buying low and selling high, and tax selling. To buy and sell mutual funds, you as an individual investor would go directly through an investment company. Mutual funds trade just once a day after close of market.
Exchange-Traded Funds
An exchange-traded fund (ETF) uses pooled investor funds to invest in a basket of securities. The key difference is that ETFs are bought and sold on stock exchanges throughout the trading day. Although most ETFs are passively managed index funds, there are some actively managed ETFs.
Hedge Funds
A hedge fund uses pooled funds from investors to invest in a mix of assets with the goal of receiving positive returns. In this case, though, an investment manager attempts to achieve market-beating returns, and typically receives part of the fund’s profits as a performance fee. Hedge funds are less regulated than mutual funds so investment managers have more leeway with their strategies. They are allowed to use risky strategies that are mostly off limits to mutual funds, such as margin trading and leverage, to boost their returns. Because they come with higher risks, hedge funds are only available to wealthy accredited investors.
Private Equity Funds
A private equity fund focuses on long-term investments with its investor-pooled money—typically with time horizons of 10 years or more. A private equity fund may take a controlling stake in a company and become actively involved in management, or it may focus on investing minority stakes in startups or rapidly growing companies. Like hedge funds, private equity funds are limited to accredited investors.
