What Are the Different Types of Investment Funds? (+ Examples)

What are the different types of investment funds? I’m so glad you asked. The most important word in that question is “funds,” as it will shape the conversation we’re going to have here today to answer that question.

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If you’re just starting out in your investment career, you’re asking this question to understand what your options are, as you begin to develop your fluency in the language of the investment space. This is an exciting moment for you, but I want you to prepare yourself to continue your education journey beyond this article. 

The investment world is a complicated one. So, once you understand the fundamentals of investment funds as we’re going to discuss together, I would encourage you to dive into more books and resources to learn as much as you can. 

Now, if you’re a more experienced investor who is working with a financial advisor — or you’re trying to choose a financial advisor — you’re in a good spot. But you may also need a helping hand in making sure you can keep up with all the terms and language you may have thrown at you from guys like me in the financial services industry. I’m here to help make that easier for you. 

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Of course, you could be planning for your retirement or a new chapter in your life, and you’re doing your research. Good on you, I’m glad to have you here. 

No matter how seasoned of an investor you are, or where you are in your financial journey, you’re in the right place. An educated investor is a smart investor, which is why taking a few minutes in your day to understand your options and proper definitions of those options (in this case, investment funds) is so important. 

So, today, we’re going to discuss what an investment fund is at a high level, what the different types of investment funds you need to be aware of (in simple terms), some of their risks or disadvantages, and who should be investing in them. 

What Is an Investment Fund?

An investment fund is a pool of investments. It’s a package that is defined by the Security and Exchange Commission (SEC), possibly the Internal Revenue Service (IRS), insurance commissions, Financial Industry Regulatory Authority (FINRA), and other government agencies and entities.

And just like anything having to do with money or Wall Street that the government gets involved with, things can get a bit complicated with investment funds. However, there are three primary types of investment funds every investor should be aware of — mutual funds, ETFs, and hedge funds. 

What Is a Mutual Fund?

A mutual fund allows you to pool your money with other investors, so you can “mutually” buy investments (e.g., stocks, bonds, and so on). Think of a mutual fund like a basket of securities. Imagine for a moment you, me, and all of our friends pooled our money together. Then we hired an investment manager and told them to go buy a bunch of stocks with that pool of money. 

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As a note, when I say a “pool of money,” that doesn’t mean you can’t get your money out, as if the fund doesn’t know how much you’ve put into it. Your funds, in a way, still have your name on it. 

How Do Mutual Funds Work?

Now, when your money is pooled together, it gives your fund leverage. Not in the borrowing sense, but rather it gives some breadth and economies of scale to do bigger investment projects. That’s very important in the mutual fund space because as the investors have pooled their money, a manager then purchases individual investments known as securities within the parameters designed or determined by the mutual fund. 

So, as we've all pooled our money together in our mutual fund, it allows that manager to do more for the bigger pool of money or the bigger basket of money than that manager could do just with your money alone. (That is unless you have a few hundred million, of course.) They may manage that mutual fund with stocks, bonds, commodities, real estate, and currencies. We’re talking about all forms of securities in all of their various forms — U.S. large-cap, mid-cap, small-cap value, growth blends, international, developed, emerging, etc.

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Another thing you need to know about mutual funds is they only settle once a day, at one daily price, typically around 4 p.m. Eastern. That means an investor only buys or sells a mutual fund once a day. There are other restrictions around mutual funds, as well, which means they aren’t the best trading tools. Meaning if you’re looking to buy and sell all day long, mutual funds are not for you. 

Which Investors Should Use a Mutual Fund?

Typically, mutual funds work best for you investors out there who are utilizing a “buy and hold” strategy, who are also seeking diversity in your overall investment strategy.

WHat Is an Exchange Traded Fund (ETF)?

Although an exchange traded fund (ETF) is often taught by some as being the same thing as a mutual fund, they are not the same thing. ETFs are a basket of stocks, bonds, commodities, and alternatives that mimic an index, and are transparent in nature. 

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The greatest advantage of an ETF is that we know what index we’re getting out of the investment, and there are active managers who utilize a rules-based index, which is becoming more and more common. However, that index must be rules-based, predetermined, and set. 

How Do ETFs Work?

Unlike mutual funds, an ETF can also be traded all day, similarly to the stocks you see on various exchanges, but not exactly. This can quickly devolve into an incredibly nuanced and detailed discussion on how ETFs deviate from traditionally traded stocks. For the most part, however, you can go buy and sell ETFs pretty regularly, particularly if it’s a broad market on that ETF. It can be a wonderful training tool in those cases. 

I do want to share one word of warning about trading ETFs. On an extremely volatile trading day, their price can move away from the underlying value of the securities. Again, I’m only speaking to extremes here, but if you’re going to trade ETFs, this is something you do need to be aware of. 

Which Investors Should Use an ETF?

Like mutual funds, if you’re an investor utilizing a “buy and hold strategy” and seeking diversity in your overall investing approach, you can do very well with ETFs. 

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This is particularly true if you’re a cost-conscious investor. Often, they are the lower-cost option, if you’re having to choose between them or mutual funds. In fact, ETFs can be the most or one of the most inexpensive investments in the United States investment world.

Traders also use ETFs when they’re looking for specific markets, wherein the underlying securities in those markets are very thinly traded, but there is an ETF that is broadly traded.

What Is a Hedge Fund?

A hedge fund is another type of pooled investment under the oversight of an investment manager; in this case, a “hedge fund manager.” These can be Limited Liability Partnerships (LLPs), trusts, or other investment entities. However, unlike mutual funds and ETFs, they are more “exotic” in nature, due to the fact that they pursue alternative investments. 

How Do Hedge Funds Work?

Alternative investments in this case simply refer to anything that isn’t a stock or a bond — currencies, commodities, both public and private, and so on. Additionally, hedge funds use leverage. They use high-frequency trading, and they can go long and short in the positions. They also can have very specific styles.

Which Investors Should Use Hedge Funds?

If you want to explore hedge funds, you should be a sophisticated investor — or a “qualified” investor, as the SEC puts it. You should also be an investor who is genuinely interested in seeking out alternative investments.

Maybe you’re utilizing a hedge fund, but seeking a diversity from some of your core investments elsewhere. You could be utilizing a hedge fund to “hedge,” to place a layer of protection on investments elsewhere. Or you could want investments that use exotic risk management tools. 

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No matter who you are, when it comes to hedge funds, you need to know what you’re doing. You need to do your homework, and you should never go into hedge funds lightly. Yes, they can be wonderful investment tools, and there are legendary, brilliant managers out there who run them. But you’ll need more education than this article before I would even consider diving into them. 

Investments Should Support a Larger Goal

Remember, investment funds at a high level are a basket of securities managed by a professional. They should offer you a specific strategy, a specific diversity. I want you to always use a fund that fits your financial plans, which are built to lead you to your life goals — or at least a portion of your life goals where money can help you achieve something meaningful or important to you. 

Wealth accumulation should never be the goal itself. Money is a tool that can empower you to do great things for yourself and (hopefully) others. So, don’t fall in love with your investments or investing ideas. Yes, this is an incredibly fascinating world, which is why I’ve made it my career. But your investments should always be in service of something greater than the numbers you see ticking up in your investment accounts.

Of course, if you have personal questions about how these types of investment funds could figure into your own investing or financial plan, schedule a time to talk with us. We’re happy to discuss your specific circumstances.