Investment vehicles help you earn investing profits. But what kinds of investment vehicles are there and which one is best for you?

What Are Investment Vehicles

An investment vehicle is an instrument, product, or container that houses a particular investment strategy that allows investors to earn a positive return through income and capital gains. Investment vehicles include individual securities such as stocks and bonds as well as pooled investments like mutual funds and ETFs.

Investment vehicles can be categorized into two broad types:

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1. Direct investments
2. Indirect investments

Direct Investments

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.

Direct investments do not have a professional portfolio management team selecting the investments for the investor. Instead, the investor has complete control over which assets or securities to purchase.

Indirect Investments

Indirect investments are investment vehicles that hold direct investments selected by professional portfolio managers. Investors pay the portfolio managers a management fee to choose and monitor direct investments.

Pooled Investment Vehicles

Pooled investment vehicles are the most common type of indirect investments. Examples of pooled investment vehicles are open-end mutual funds, closed-end funds, and exchange-traded funds (ETFs).

Pooled investment vehicles are created and led by sponsors, such as Vanguard and iShares. The sponsor hires or retains a portfolio management team to select direct investments to be held in the pooled vehicles. Shareholders of the pooled investment vehicle own the vehicle itself, rather than the underlying direct investments controlled by the vehicle.

Public and Private Investment Vehicles

Direct and indirect investments can also be categorized by whether they are public or private.

Public Investment Vehicles

Public investment vehicles are available for purchase by the general public. Most public investment vehicles are purchased using a brokerage firm that acts as a middleman to facilitate the trade.

Some public investment vehicles, such as ETFs and closed-end funds, trade on an exchange. The exchange matches buyers with sellers. Other public investment vehicles, such as open mutual funds, are bought directly from the sponsor, although a brokerage firm may assist with the purchase.

Private Investment Vehicles

Private investment vehicles are not available to the general public. Often investors in private investment vehicles must meet certain income or net worth thresholds to participate in the investment offering. In the U.S., there are different levels of qualification to be able to invest in a private investment vehicle, such as being an accredited investor or a qualified purchaser. Examples of private investment vehicles include hedge funds, private real estate investment trusts, such as Blackstone’s BREIT, and venture capital limited partnerships. Many private investment vehicles are considered alternative investments because they invest outside of traditional public stock and debt markets.

Investment Platforms

An investment platform is an intermediary that connects buyers and sellers of investment vehicles. A brokerage firm such as Vanguard, Fidelity, and Schwab provides access for individual investors to purchase public investment vehicles such as stocks and ETFs.

A crowdfunding platform, such as Fundrise or OurCrowd, provides access to private investment vehicles, including private indirect investment funds or direct investments in individual start-ups.

Investment Vehicle Characteristics

Investment vehicles have characteristics that can help investors decide which vehicles are the best fit for their portfolios. Here are the most important attributes when evaluating investing vehicles:

1. Expected return
2. Risk
3. Liquidity
4. Cost
5. Structure
6. Pricing

Expected Returns

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An investment vehicle’s expected return is a realistic assumption of how much the investor could earn holding the investment over an intermediate-to-longer-term period. The expected return is primarily driven by direct investments—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:

1. The investment’s cash flow in the form of dividends, interest, or rents.
2. How much the cash flow is expected to grow over time.
3. What are investors paying for the cash flow now versus in the future.

Chapter Three of my book, Money For the Rest of Us: 10 Questions to Master Successful Investing goes into great detail regarding how to estimate the expected return of stocks, bonds, and other asset classes based on these three return components.

Risk

An investment vehicle’s risk measures how much an investor could potentially lose if the investment falls short of the expected return. The worst-case historical or expected loss for an investment vehicle is known as its maximum drawdown.

Risk is also measured by volatility. Volatility 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. That means volatile investments can suffer greater losses than investments with lower volatility. A less volatile investment will see most of its annual returns congregate around the expected return. A volatile investment will see more returns well above or well below the expected return compared with a less volatile investment.

Liquidity

Liquidity measures how quickly and easily an investor can sell an investment to get cash. An investment is more liquid if there is a large pool of willing buyers and sellers, as well as a place where those buyers and sellers can transact. More liquid investments have higher trading volumes, so investors can be confident that prices are up-to-date and not stale.

Illiquid investments have fewer buyers and sellers. Some illiquid investments might only have one buyer, the investment sponsor. The lack of buyers and sellers and the infrequency of transactions may require sellers to take a lower price than they would like and while buyers will have to pay more than they would like.

In other words, there can be a cost to converting a less liquid investment into cash. Sometimes that cost is explicit in that the sponsor charges a fee to exit a position. Or the cost to exit an illiquid investment could be indirect in that the price is lowered to reflect the lack of buyers and sellers.

Public investment vehicles are typically more liquid than private investment vehicles because public investments have more buyers and sellers and a centralized place to transact.

Less liquid private investment vehicles should have higher expected returns than liquid investment vehicles that hold similar assets in order to compensate the investor for the illiquidity. That additional return compensation is called an illiquidity premium.

Costs

Cost measures how much an investor pays to buy, sell, and hold an investment vehicle. Costs include commissions to enter and exit an investment as well as the fees paid to the vehicle sponsor to manage the investment. Investment vehicle costs also include taxes on income and capital gains.

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, have the highest costs because the underlying investments are complex and take a great deal of day-to-day oversight by the portfolio management team. Consequently, private investment vehicles typically have high asset management fees.

Public, indirect investment vehicles, index mutual funds, and ETFs have the lowest costs. These investment vehicles seek to replicate a specific market benchmark by holding all or most of the target index’s underlying holdings. Index funds and ETFs have lower costs because managing these investment vehicles requires less day-to-day research to select direct investments, and there is less trading in the underlying holdings. Index funds and ETFs are also more tax-efficient because there are less frequent sales of the underlying holdings that could generate capital gains.

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Actively managed open-end mutual funds and closed-end funds are the public indirect investment vehicles with the highest costs. The management fees are higher to compensate the portfolio management team for the additional work in selecting direct investments. Trading costs are also higher for actively managed funds because there is more trading.

Investors should only pay the higher costs for private investment vehicles or actively managed funds if they believe the costs are justified in that the investment will perform better than lower-cost alternatives.

Structure

An investment vehicle’s structure refers to how it is organized and accessed by investors. Structure includes a number of the attributes already covered in this article, such as whether the vehicle is direct, indirect, public, or private. Structure also consists of the investment vehicle’s liquidity terms, costs, and whether the investment vehicle uses leverage. Leverage means borrowing money to invest in assets in order to increase the potential return.

Additional considerations when researching the structure of an investment vehicle is whether there is an account minimum and how the vehicle is taxed.

Investment vehicles have offering documents that describe the opportunity’s terms and structure. Public investment vehicles have a prospectus, while private vehicles have an offering memorandum. Investors should study these documents closely in order to understand the vehicle’s structure.

Pricing

A final attribute to consider when evaluating an investment vehicle is how its market price is set. Some investment vehicles’ market prices are determined by trades on an exchange in what is known as the secondary market. Stocks, ETFs, and closed-end funds are examples of investment vehicles where the market price is set by trades in the secondary market.

The price of other indirect investment vehicles is set by the sponsor based on the value of the underlying holdings. An open-end mutual fund is an example of this type of investment vehicle.

At the end of each trading day, the mutual fund sponsor determines the fund’s net asset value per share. The net asset value (NAV) is calculated by taking the market price of a fund’s assets, including cash, subtracting any liabilities, and dividing by the number of shares outstanding. Mutual fund sponsors set the market price per share equal to the NAV. The fund sponsor then creates and redeems shares at the market price.

Indirect investment vehicles such as ETFs and closed-end funds whose market prices are set in the secondary market will often see those prices differ from the net value. The ETF or closed-end fund can sell at a discount or premium to the NAV.

ETF sponsors work with institutional traders known as authorized participants to try to keep the ETF price close to the net asset value. Closed-end funds do not have a mechanism to narrow the discount or premium to the net asset value. You can learn more about closed-end funds in this guide How to Invest in Closed-End Funds

The market price or value of other investment vehicles, such as rental real estate, is determined through an appraisal process.

Which Investment Vehicles Are Best?

For most individual investors, the core of their portfolio should be made up of index mutual funds or ETFs. These public pooled indirect investment vehicles are the most cost-effective way to get diversified exposure to stocks, bonds, and real estate.

Investors who want to be more active in seeking higher returns can opportunistically complement ETFs and index mutual funds with closed-end funds that are selling at greater than average discounts and actively managed mutual funds. You can learn how to invest in closed-end funds here.

Finally, individuals who want to earn potentially even higher returns should consider less liquid private direct and indirect investments.

A word of caution: Selecting private investments and active public investments requires skills that many investors don’t have. It is common for many private investments and actively managed public investments to underperform index funds and ETFs. That is why most individuals should focus on index mutual funds and ETFs.

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