There are numerous benefits associated with a pooled investment fund. These include:
- Diversification: The process through which investors buy many types of assets to lower the overall risk.
- Liquidity: The ease with which an investor can easily buy and sell an asset. Liquidity helps an investor to avoid tying up a lot of their money in one asset.
- Transactional costs: Pooled investment managers buy and sell assets on a large scale, which lowers the cost per dollar invested. Therefore, the transactional costs are lower than those involved in trading stocks, where brokers charge a commission per trade. These commissions lower the profits for the investors.
- Asset management: Pooled investment vehicles are overseen by professional managers. Therefore, although individual investors have little experience with the financial market, they can still make profits by tapping into the experience of professional fund managers.
By participating in pooled investment vehicles, investors gain access to a wider range of assets and can also negotiate for better rates.
To unlock this lesson you must be a Study.com Member.
Create your account
Pooled investments also have various drawbacks. Although diversification can help mitigate idiosyncratic or unsystematic risk, it cannot deal with other types of risks, such as systematic, inflation, and macroeconomic risks. Idiosyncratic risk is one that affects one asset at a time. The other types of risks affect all assets at once. Systematic risk, also known as market risk, is the risk that has an effect on the entire market rather than a specific sector or stock. This risk cannot be predicted and, therefore, cannot be avoided. It can include occurrences such as wars, inflation, and recessions. Diversification is also not possible where firms focus on industry-specific pooled investment vehicles.
Funds also make an investor give up control of their money to professional managers. Consequently, the investors also incur management fees which reduces profits.
To unlock this lesson you must be a Study.com Member.
Create your account
Pooled assets vehicles have various impacts on taxes. Effective management of tax is critical in minimizing tax impact on realized capital gains. Some of these impacts include:
- Reducing tax through IRA or 401(k): When an investor invests in passively managed funds that have fewer events leading to realized capital gains, it is more suitable to hold the investment in a brokerage account, which is taxable. However, when the fund is actively managed, it would be more suitable to hold the investment in an IRA or a 401(k).
- Reducing tax by timing distribution: Funds are required to distribute net dividends and capital gains within a year. Investors pay taxes on this income even if it is reinvested in other shares. To reduce taxes paid, funds can hold stocks for several years. During this period, the appreciated value of the stocks is not distributed and hence is not taxable. The managers can then sell the stock once the managers decide that it has attained its full value. Consequently, the number of events that would have led to realized capital gains are reduced, thus reducing tax.
- Investing in tax-exempt securities: Funds can invest in tax-exempt securities such as municipal bonds. As a result, investors get freed from the taxes.
To unlock this lesson you must be a Study.com Member.
Create your account
Pooled investment vehicles are large investment funds that many individual investors come together to create with the intention of investing in assets that would otherwise be only available to accredited investors. They include mutual funds, where investors pool money and invest in vehicles already invested in bonds and stocks. Another example is an exchange-traded fund which tracks the performance of a specific industry or asset. Pooled investment vehicles take investment from many individual investors and invest it in different assets. Therefore, they differ from fixed-income investments, which are all investment vehicles held by a single investor. Pooled investment can be open-ended or closed-ended. An open-ended fund does not have a limit on the number of people who can invest. In contrast, a closed-ended fund limits the number of people who can invest and the investment level.
Pooled investment vehicles have various benefits. They have a high liquidity which describes how easy it is to buy or sell a particular stock. In addition, they allow diversification which is the process by which investors can buy different assets to reduce the overall risk. Diversification is an advantage as it can help address unsystematic or idiosyncratic risk, which is a risk that only has an impact on one asset. However, pooled asset vehicles are not used in mitigating inflation, macroeconomic, and systematic risks. These types of risks affect the whole portfolio at once. Pooled investment funds have various tax implications. Investors can reduce their taxes by holding their investments in 401(k) and IRA, buying tax-exempt securities, and timing the distribution of capital gains.
To unlock this lesson you must be a Study.com Member.
Create your account
Additional Info
Pooled Investment Vehicles
Rob started his first salaried job a year ago. He saves a considerable portion of his salary and hence a large amount has built up in his bank account. The fund is idle and he wants to invest it to earn a higher return.
He has approaches Jill, a financial advisor, who reviews his investment policy statement. She suggests pooled investment vehicles, which combine funds from a large number of small investors and make investments in different assets. The most common forms of pooled investment vehicles are mutual funds, pension funds, hedge funds, and exchange-traded funds.
Benefits of Pooled Investments Vehicles
Liquidity
Rob asks how pooled funds would benefit him. Jill says that one of the advantages is liquidity, or the ease with which assets can be bought and sold. Pooled investment funds are highly liquid and usually trade a number of times per day. Rob could buy or sell them whenever he liked. The liquidity of pooled investment funds, in general, is higher than bonds and only lower than common stocks of large corporations.
There are other benefits to pooled investment funds like diversification, reduced transaction costs, management options. Jill goes over them in a bit more detail.
Diversification
Diversification is the process of investing in a large number of assets to reduce overall risk. Pooled investment vehicles invest in a large number of assets with different risk characteristics. This way, risk is distributed over a large number of assets. When one asset does not perform well, others may excel and some might perform better than expected. In the long run, the investment earns proper risk-adjusted returns.
Diversification is easy for pooled investment funds because they have huge amounts of funds and can invest in a number of assets. A small investor can invest in only a few assets and cannot diversify. Pooled investment funds can invest in assets that require large investments such as real estate, private equity, etc. A small investor cannot purchase a large building for investment to earn rental income, but a pooled investment firm can.
Transaction Costs
Transaction costs are the expenses incurred while buying or selling securities. Jill informs Rob that when small investors purchase securities they incur high transaction costs - as high as 3%. However, pooled investment funds can have their own agreement with the broker/dealer and reduce this cost extensively due to economies of scale. Thus, transaction costs are minimized.
Asset Management
Pooled funds can hire good asset managers who understand the market and are likely to offer higher risk-adjusted returns. The managers charge a fee, but the excess return can be higher than the fee charged. Dedicated management helps ward off risks and offer research in new investments.
Risks of Pooled Investment Vehicles
Okay, Rob thinks, but what about the risk? Jill informs him that the risks faced by the pooled investments are similar to other assets. However, as a result of diversification, unsystematic risk is reduced to a minimum. Unsystematic or idiosyncratic risk is the risk unique to each asset and is removed due to diversification. However, systematic or market risk, which affects all assets at once, cannot be removed and is present in pooled investments. The systematic risks include inflation risk, interest rate risk, currency risk, and other macroeconomic risks.
There are some pooled investment funds that target a given industry. In such a case, they are not properly diversified and are faced with idiosyncratic risk in addition to the market risk. For example, a fund investing solely in computer hardware would not be diversified from the rise in prices of computing peripherals or a decrease in the demand for hardware.
Tax Implications For Pooled Investment Vehicles
Rob is concerned about taxes paid on investments. Jill assures him that a number of pooled investments are structured to reduce the amount of taxes paid. This can include timing the distribution in order to reduce tax.
Capital gains tax might be lower and hence the fund may postpone distribution. Pooled investments do incur taxes on capital gains and return generated, however, holding such funds through an IRA or 401(k) could reduce tax implications. In addition, funds may invest in tax-exempt securities to minimize tax paid.
Lesson Summary
Pooled investment vehicles combine funds from a large number of small investors and make investments in different assets. These are commonly mutual funds, pension funds, hedge funds, and exchange-traded funds. The benefits of pooled investment vehicles include:
- Liquidity -the ease with which the assets can be bought and sold. Pooled investment funds are highly liquid and usually trade a number of times per day.
- Diversification - investing in a large number of assets to reduce overall risk. Pooled investment vehicles invest in a large number of assets with different risk characteristics.
- Transaction costs - the expenses incurred while buying or selling the securities. Pooled investment funds can reduce transaction costs due to economies of scale.
- Asset management - good asset management can lead to higher risk-adjusted returns.
- Tax benefits - pooled investment funds can be structured to reduce taxes payable.
To unlock this lesson you must be a Study.com Member.
Create your account
