A quick survey of investment vehicles

A version of this article first appeared in the December 2020 issue of Morningstar fund investor. Download a free copy of Investor Fund by visiting the website.

Mutual funds are in large part the creation of the Investment Company Act of 1940, a well-crafted piece of legislation that laid the foundation for the massive growth of mutual funds. This helped establish principles of transparency, fiduciary duty and independent oversight which allowed trust to grow as fund companies also grew.

Some of the key things that have helped funds grow are daily net asset value, custodian securities, boards of directors, clear disclosure of holdings and fees, and SEC oversight.

But other investment vehicles are also developing, so I thought I would take a moment to explain what they are and how they stack up against mutual funds. I have also included a chart showing the relative attractiveness of each compared to mutual funds.

Source: Morningstar.

Exchange traded funds
ETFs participate in traditional open-ended funds with a few key attributes. ETFs trade throughout the day, and although ETFs are in fact mutual funds governed by the Law of 40, they do some things differently. While individual investors buy and sell an ETF much like a stock, institutional investors can perform in-kind arbitrage on baskets of stocks in the event of a price differential. This keeps the ETF’s prices largely in line with the NAV, and it means the fund doesn’t make taxable gains every time someone redeems stocks.

So, they trade on the stock exchange, but you get a price close to the NAV under normal market conditions. For institutional traders, ETFs often replace futures contracts for their short-term trading needs. So, you have a significant advantage for taxable investors over an actively managed open-ended fund, which will likely pay out capital gains in an upward year. You still have to pay taxes if you sell at a profit, but you are unlikely to do so along the way. The difference to large company open index funds, however, is not great, as they tend to realize losses in a way that spares shareholders capital gains. There are exceptions where zombie index funds have spat big bills.

This brings me to a poorly understood aspect of ETFs. People sometimes view the open-end / ETF debate as active or passive. But of course there are many open index funds and around a fifth of ETFs are actively managed. So, when it is suggested that ETFs are cheaper than open-ended funds, what is really being said is that the liabilities are cheaper than the assets. But ETFs are generally also cheaper to have marketing costs removed. Some open-ended passive funds are cheaper than their ETF counterparts.

Tellingly, Vanguard offers both open and ETF versions of many of its index funds, and in general, the ETF is 1 basis point cheaper. This cost advantage stimulates the flow of Vanguard’s open share classes to its ETFs. ETFs have the advantage of not having to pay broker service fees. Yes, Vanguard provides services at cost, but the rest of the industry wants a profit.

When it comes to active ETFs, one of the challenges is that the normal ETF structure requires a level of portfolio transparency that can enable leaders of large equity strategies. New, less transparent ETFs have popped up to address this issue, but there isn’t much to show for it.

Collective investment funds
CITs act like mutual funds, but with different disclosure and regulation. These are pooled investments, but they do not have any filing requirements with the SEC or boards of directors. As a result, they are generally less expensive than their mutual fund counterparts. On the other hand, you lose transparency, but these are often very similar to a mutual fund. CITs are regulated by the Office of the Comptroller of the Currency and must go through trustees.

Typically, these are found in 401 (k) plans and are managed very similarly to a mutual fund. So, you might want to use this mutual fund as a proxy in monitoring your portfolio so that you can include it in top-down portfolio analysis and get a feel for your CIT’s performance.

Accounts managed separately
They are another close cousin of mutual funds. They are sold in part on the basis of exclusivity. Rather than pooling your money with commoners, you can have an ADM, which is managed for you, provided you have $ 1 million to invest in the strategy. The minimums for SMA platforms and strategies vary by brokerage. Sellers sometimes exaggerate this as a portfolio manager customizing a strategy for you, but mostly that’s wrong. For the most part, ADMs use the same cookie cutter, although you can request to withdraw something like tobacco or companies whose name begins with the letter W.

However, ADMs have some real advantages. One is taxes. When you buy a mutual fund, you are subscribing to a strategy that may already have accrued gains. When mutual funds distribute these gains, they come back to everyone, whether or not they made a profit. So, you have to pay taxes if you hold this fund in a taxable account.

On the other hand, with the SMA, you start with a clean slate on taxes, and the titles are kept in your account. You only have to pay taxes when the SMA Manager sells your holdings at a profit. Considering the current high stock levels, this is a real advantage. No, it is not tax exempt. You will still pay when the SMAs make a profit and when you sell the SMA if it is profitable, but at least you won’t start paying taxes. ADMs also tend to be cheaper because they are less regulated and have large accounts. SMA fees are not fixed, so you will need to take a close look at the fees offered and compare them with some mutual funds of the same strategy.

The only thing ADMs don’t do well are bonds. This is because bonds trade in large amounts that cannot be easily chopped up like stocks. As a result, bond SMAs tend to have targeted portfolios of just 20-30 stocks versus a portfolio of hundreds like the typical bond fund. Most people want their bond fund to provide income and a smooth ride, so having greater issue risk is not a welcome trait. This will double in high yield areas and in other areas where there is a real risk of default.

Closed-end funds
Closed-end funds aren’t that different from open-end mutual funds and ETFs, except the price you get will rarely be at net asset value. Funds can be traded at discounts or premiums and thus add a rather unfortunate element of uncertainty. In general, closed-end funds trade at a discount to their net asset value, which is really disappointing if you bought on the IPO.

Closed-end funds have a defined asset base that the managers then manage as they see fit. This means that the fund is not vulnerable to the impact of flows; this might help when investing in less liquid securities.

But there are downsides. There is less disclosure. Closed funds can change managers and then take their time to tell you. Plus, they cost more than most open-ended funds because they have a fairly small asset base. But maybe the biggest downside is that it’s hard to fire the manager. Some closed-end funds seem to have the function of providing managers with a secure income stream because they don’t use any other vehicle, and they also don’t have an incentive to do a good job because you can’t actually withdraw money.

Finally, it should be noted that closed-end funds can and do use more leverage than most mutual funds. If you see a big return on a closed fund, it’s because it uses leverage and is likely trading at a discount to the net asset value. There are some good companies, like Pimco, that run closed funds, so I’m not saying I would avoid them altogether, but I wouldn’t want a closed fund to be a big part of my portfolio, and I’m sure that ‘it was run by a company I really trusted.

Hedge funds
Hedge funds are a less regulated vehicle for very wealthy individuals and institutional investors. Although their name implies that they cover exposure to equities, there is a wide variety of alternative and traditional strategies.

Some of the smartest minds when it comes to investing can be found in hedge funds. In particular, many of the best quantitative investors are found in hedge lands, as running an effective hedge fund can be incredibly lucrative. Funds typically charge 2% of assets and 20% of profits. You can’t do this in mutual funds because performance fees have to swing back and forth the same – and hedge fund managers don’t want to subtract 20% from losses.

The bad news for individual investors is that the best strategies are either closed to new investors or limited to large institutions. Usually things for investors with less than $ 100 million are the weakest, and when you pay fees like that you need some insanely good stuff just to get closer to what you would get in a 60/40 low. . -common cost sharing fund.

Variable annuities
I saved the worst for last. The most important thing to know about variable annuities is that they charge you a BIG commission. When advisors recommend a VA to you, they mention the tax benefits, but what they’re really thinking about is that big commission.

The VAs come in a variable annuity policy with a sub-account insurance fee inside. These are tax-efficient structures that hold a portfolio of mutual funds. Unlike annuities, the value varies depending on the underlying assets. Some advisers have criticized the use of VAs in 403 (b) accounts, although the value to investors varies widely depending on their needs and the quality of the VA.

Regardless of the vehicle, it pays to keep an eye on costs and the quality of management. Most of the time, ETFs and open-ended funds are the best options, but it’s good to understand your choices and be open to better opportunities when they arise.

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Chinese local government investment vehicles escape borrowing limits

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Regional governments across China are escaping borrowing limits by shifting assets into the books of local investment firms to lower their official debt ratios, executives and officials say.

This practice has enabled local government funding vehicles to raise more money for infrastructure and other construction projects. But analysts warn that many assets are of poor quality, paving the way for an increase in bad debt after a wave of bond defaults at government-backed companies in recent weeks.

“A lot of our assets don’t generate much economic value,” Liu Pengfei, chairman of Taiyuan Longcheng Development Investment, a LGFV in northern Taiyuan City, said at an investment conference last month. “Taiyuan government gave them to us so that we could meet. [the debt-to-asset] requirements set by our creditor banks and bond investors.

TLDI focused on infrastructure projects. Today, it is a large, diverse operator of everything from parking lots to tourist attractions, many of which barely stay afloat.

According to public records, the total assets of 960 major LGFVs that regularly disclose their financial results have increased by 40% over the past four years. However, their income and net income only increased by 6% and 4% respectively.

“A Rmb100bn [$15.3bn] a company will be no less likely to default on its debt than a Rmb 10 billion company simply because of a size difference, ”said Bo Zhuang, chief economist for China at TS Lombard, a group of research.

The surge in acquisitions is expected to continue as local governments turn to LGFVs to boost the economy in the wake of the coronavirus pandemic. The Shaanxi provincial government said in a statement in October that it would transfer “as many assets as possible” to LGFVs so that they can double their borrowing over the next two years. The measure “would effectively eliminate the risks associated with public debt,” the government added.

“The bigger we are, the more we can borrow,” said an executive from Yan’an City Construction Investment Corp, another Shaanxi-based LGFV.

The executive said YCCIC has been entrusted with dozens of state-owned enterprises by the Yan’an municipal government since 2018, ranging from hotels to water treatment plants. Most of them struggle to make a profit.

Nonetheless, the executive added, YCCIC was able to borrow more as its larger size translated into a better credit rating, which was upped a notch to double A plus in October. Over the past two years, YCCIC’s outstanding bank loans have more than doubled.

Many local governments had previously ceded valuable land to their LGFVs free of charge in order to increase their borrowing capacity. But the practice was banned by the central government, forcing local governments to resort to lower-quality asset transfers.

Chinese banks, the largest LGFV lenders, are comfortable lending to the largest public investment firms, even as the quality of their underlying assets deteriorates.

“We have an obligation to support government-controlled enterprises as long as they meet core funding requirements,” said an executive from the Bank of Xi’an.

The rating agencies, on which LGFVs rely to access the bond market, are also generally favorable. An executive from the China Chengxin Credit Rating Group, one of the largest in the country, said the company paid more attention to total assets than earnings or cash flow. “The injection of government-controlled entities, whether profitable or not, into LGFVs is a sign of state support,” the official said. “It’s a plus for their credit rating. “

Some investors, however, are not convinced that the frenzy of LGFV acquisitions will make them less likely to default.

“Expanding LGFV balance sheets will not remove credit risk,” said Dave Wang, a Shanghai-based fund manager specializing in buying LGFV debt. “They may erupt at a later date, on a larger scale.”

Some LGFV executives have said they are aware of the potential risks as they seek to create more market-responsive businesses.

An executive from Jiangdong Holding, an LGFV in central Ma’anshan city, said his group had acquired two smaller peers and wanted to emulate Temasek, the Singaporean public investment group, even though it could not match its return on capital for the foreseeable future.

“Temasek has enjoyed a 16% annual return on investment for many years,” he said. “We would be satisfied with 1.5%. “

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