Settling confusion: A guide to retail investors

Evaluating different investments and opportunities.

ETFs

The first question that should be asked is; ‘What are ETFs?’

ETFs stands for “Exchange-traded funds”. These are the funds that are traded on the stock markets and generally track down a particular index. Compared to investing in a single stock or bond where you get a single stock for a said amount, investing in an ETF is relatively different. However, in the case of ETFs, since you are essentially investing in an index, this means that you get to have multiple assets instead of just one. What this does, in turn, is that it diversifies the portfolio and reduces the risk. ETFs must be thought of as a pooled security much like that invests in a particular industry (like mining, real estate, technology, financial services etc.) or simply follows an index (like S&P500 Index, Russell 2000, Nasdaq etc.). It is important to note that the basic principle behind ETFs is to invest in the assets that already do exist in these indices or industries. The next question that arises next is how can one buy ETFs? Since much like the shares, the ETFs do trade on the markets, they can be bought from the markets at a price that has been decided by the markets. The next question that is natural to be asked is which ETF to invest into? Hundreds of ETFs exist out there which are managed by different corporations as a means to provide the investors some freedom in what all they can invest into. ETFs come in handy when a person does not wish to take on the risk that a certain asset carries with itself but definitely wants to participate in the upside that follows. By diversifying, ETFs are a secure means to limit the risk. However, that being said, it must be understood that since the risk is limited, so is the upside. An almost inevitable question here is who can have their own ETF? Can an individual start their own ETF? Although the number of ETFs is in hundreds, it is important to know that various restrictions are levied on these ETFs and upon their origination, they have been approved by the regulators. Since they trade on the markets, ETF managers have to comply with all restrictions that have been levied by the SEC. ETFs sponsors enter into contractual relationships with one or more financial institutions known as “Authorised Participants.” Only these APs can purchase individual shares from the ETFs but that must be done in large blocks called ‘Creation Units’. Then, the AP deposits cash and other securities with the fund in exchange for ETF shares. Once this is done, AP is free to sell them to the retail investors. At this point, what is important to be addressed is the fact that just because ETFs are subject to SEC regulations, it means in no way that investors should trust the managers blindly. Rather, ETFs should be looked at with greater detail to make sure the assets that fall in the category are well known and the person would be comfortable to invest in the assets outside of ETFs as well. How it really works is that investors can not purchase shares directly from other retail investors.

Mutual Funds

Much like ETFs, mutual funds are managed funds that pool money from the shareholders to invest in the securities. Mutual funds have prospectus in which are written the investment objectives. A mutual fund’s portfolio is structured and maintained in a way that matches the investment objectives. Mutual funds invest in a large number of assets and this makes the shareholders risk averse to a lot of extent. Since it is pooled money, gathered from hundreds of shareholders, the mutual funds make the investors participate in proportional gains and losses. Mutual funds can invest in different sectors of the market or based on the type of fund. Most mutual funds can be divided up into mainly 4 types- stock funds, money market funds, bond funds and target-date funds.

Stock Funds

As the name suggests, stock funds invest in the stocks/shares of different companies. Within this category, funds can be categorised into different classes based on certain parameters like size (small-, mid-, large-cap), investment strategy (aggressive growth, income oriented, value and others), location (domestic, foreign).

Bond Funds

These funds invest in different bonds and are a part of the fixed income category. These funds focus on instruments that pay a set rate of return, and are actively managed. The way these funds gain profit is by investing in relatively undervalued bonds to sell them at a profit later. That being said, investing in bond funds definitely comes with risks. They depend a lot on the interest rate risks and are often considered the byproduct of general market conditions/inflation rates.

Money Market Funds

The money market funds are safe and short term debt instruments that do not typically give out huge returns but the principal investment is guaranteed. These funds typically invest in the government T-bills. An important point to note here is that these investments are usually made in high grade credit securities to ensure safety of the principal and reduce the risk.

Target-date Funds

The Target-date Funds really come in handy when someone is looking for investing in securities to prepare for retirement. These funds typically invest in a mix of securities to maximise the returns till the end of a specific date. The general approach is to increase profits when the person is young which is another way of saying that the initial phase of the fund is characterised specifically to be more risky. As time passes and the risk appetite of the investors decreases, to cater for retirement, the fund starts investing in less risky- more stable assets.

What is the difference between ETFs and Mutual Funds?

Criteria	ETFs	Mutual Funds
Minimum Investment	ETFs can be bought for as little as $1	​Mutual Funds require a minimum initial investment
Control over Pricing	ETFs provide real time pricing and greater control.	Mutual Fund prices are not calculated until after the trading day and hence, lesser control.
Automatic Investments	Putting in money/ pulling out money out of ETFs automatically is not possible	​Automatic investments and withdrawals are automatic and preference based

Cryptocurrency

How cryptocurrency works is perhaps one of the most tricky questions we do not know the answer to. In simplified language, cryptocurrency is a decentralised, unregulated currency that relies heavily on cryptography and uses blockchain to operate. The reason cryptocurrency has gained so much of popularity in the last decade or so is the fact that it is controlled by the economic forces of demand and supply. Blockchain technology is a distributed ledger enforced by a network of computers. How cryptocurrency works is that with the help of blockchain technology, a series of distributed ledgers is created which is impossible to destroy. However, to use these ledgers and earn the digital currency, one needs to crack a number of encryption algorithms that might follow a certain pattern or encryption techniques. The issue with this is that the encryption is so intense and complicated that to ‘mine’ cryptocurrency, a person needs to have superior computers and algorithm techniques. This limited supply of cryptocurrency and rising demand helped bitcoin reach its peak. However, the decentralisation of cryptocurrency provides various terrorist organisations a platform to trade. Tracking the use of cryptocurrency is difficult and this is what has sparked the debate of whether it should be regulated. However, if regulated, cryptocurrency loses its very purpose. In the recent past especially due to factors like FTX collapse and other cryptocurrency trading platforms shutting down due to poor management decisions has caused the investors to suffer a lot. However, talking about cryptocurrency we can not not talk about the fact that the recent market fluctuations have caused the prices to be raised. While the very stable and old sectors like banking are fluctuating and initiating a sense of panic among the investors, it is ironic how cryptocurrency prices started rising. All being said, investing in cryptocurrency is although risky, but might be rewarding as well. The newness of this asset class requires an internalisation of risk bearing abilities and superlative investing skills which require time and precise knowledge.

Robo-Advisor

Our predictions of being surrounded by robots since the 90s are finally coming true. Today, we have at our disposal such technology that essentially removes human supervision. The first step that is taken is interacting with the investors to understand what they are looking for in their investments and how they can align their future goals with the investments that they make today. A big portion of this assessment relates to the age the investor is at and essentially saving up for retirement or other financial goals/commitments. Robo-advisors are considered a big help since they charge less fee compared to other forms and have been quite useful in creating a tailor-made portfolio for the clients. Some robo-advisors are essential for socially responsible investing, Halal investing and implementing strategies that mimic hedge funds. They are also programmed in such a way that they can handle much more sophisticated tasks such as tax-loss investing, investment selection and retirement planning.

However, it is important to highlight the fact that although robo-advisors are doing a pretty good job at the entry levels, relying on them for more advanced problems can be redundant. The rise of AI is going to help this sector grow with a lot more AUM than the recent past but realising AI is based on problems that have been dealt with in the past is important. Many problems are unique in their own ways and there may be some tweaks that better not be repeated.

Pros of each Investment Vehicle:

Exchange-Traded Funds	Mutual Funds	Cryptocurrency	Robo-Advisors
​Convenient	Diversification	​Inflation protection	​Low-cost
​Diversification	Affordability	​Accessibility & diversity	​No investment experience required
Risk reduction	Professional management	​Globalised currency	​Easy access
Dividend Reinvestments	​Flexibility	​Transparent	​Growing number of valuable services
Highly liquid	​Variety	​Private	Greater precision
Lower cost ratios as management fees is lower	​Risk reduction	​Faster transactions	​Immediate and effective solutions

Cons of each Investment Vehicle:

​Dropping dividend yields	High fees (sales charges, annual fee, management fee)	​Fuel to illegal activities	​Little to no human interaction
​Excessive intraday prices	​Lack of control	​Environmental damage	​Little investment opportunities
Limited Diversification	​No guarantee	​No guarantee	​No personalisations
​High costs	​High volatility	High volatility	​No face to face meetings
Skewed results on leveraged ETFs	​Heavy taxation	​Lack of watchdogs	​Little flexibility

Identification of appropriate tools and frameworks used by wealth managers to make investment recommendations for individuals.

The different tools and frameworks that wealth managers partake involve differing purposes and strategies that cater to investors’ needs. The first tool that managers apply is risk assessment. Investors have different risk appetites and considering their future goals is an important part of risk assessment. For example, an investor who is young might want to save up for a home and might look for aggressive strategies. On the other hand, a UHNI who is old and wants to invest to leave significant wealth for the future generations might want to invest in assets that are less risky but stable. Thus, assessing the client's risk is important and very often the very first step.

Often times, wealth managers come up with their own PMS that cater to different needs of the clients. The returns that the managers claim to achieve are big selling points for their brand image. What this means is that the managers come up with different ways to prove how they beat the markets. Investing is often considered an art which is rightly so and due credit must be given to all the managers who let their returns speak for them. However, with that being said, it is important to understand that most of the times it is a numbers’ game. Statistics can speak a thousand words all they need are the interpretations of managers. Managers have all the incentives to rig the numbers and if not that, comparing apples to oranges is definitely a practice. Many money managers compare their PMS returns to Mutual Fund returns. What they do not highlight is the difference between their portfolios’ size which can play a big factor. Investors have to be cautious of these practices before parking their money with a wealth manager.

Wealth managers use product portfolio management frameworks to provide different and better client experience. Some of the examples of these frameworks are:

Innovation Ambition Matrix- The Nagji & Tuff’s Innovation Ambition Matrix is used widely to optimise the investments in new products.

BCG Growth Share Matrix- these guide investments in both new products and in marketing by focusing on high growth, high share opportunities.

GE/McKinsey’s Portfolio Analysis Matrix- This matrix combines internal and external factors to guide investments. It looks at the investment the companies should make relative to the Industry Attractiveness and Competitive Strength.

Dependent on the type of company it is:

Large companies looking at the business unit level use the GE/McKinsey Matrix.

Tech companies use the Innovation Ambition matrix.

Mature businesses in multiple markets use the BCG Matrix.

Regulations must be followed, and hence wealth managers must give their clients frequent reports. Maintaining compliance records, automating reporting procedures, and assuring compliance with legal and regulatory requirements are all made easier by compliance and reporting software.

An important part of compliance is to understand and report the proper progress that has been made. Managers use many investment screening tools that measure the progress that has been made and compare the results to the market standards and other important criteria.

Investment research platforms form an important part of the whole process. A lot of times the success story of some model becomes an inspiration for managers to invest better. This involves active use of various methodologies that have been used. Investment research platforms help managers complete their investigations for these purposes.