What is an Investment Company?

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Definition:

Investment companies connect investors to securities either directly or through a third-party distributor to help manage investments.

🤔 Understanding investment companies

An investment company can be one of the important tools in your wealth-management toolbox. Investment companies pool your cash with that of other participants and invest in securities to meet the fund’s stated objectives. Different companies have different investment vehicles. You might go with closed-end funds, open-end funds (mutual funds), an exchange-traded fund (ETF), or something else entirely. What’s right for you depends on your investment goals and how much risk you’re willing to take to reach them. The services aren’t free. You typically pay fees to manage the fund as well as pay other operational costs. Working with an investment company does provide the benefit of professional management. A professional manager has additional resources and ideas that you have not thought about or have access to.

Example

Most people’s exposure to investment companies comes from buying (investing in) their products, such as mutual funds. Three of the biggest investment management companies in the world are BlackRock Funds (iShares), Vanguard, and Charles Schwab. Each of these firms offers many products to retail clients, including hundreds of mutual funds, exchange-traded funds, and other vehicles covering different asset classes.

Takeaway

Using an investment company is sort of like being part of a crop share…

In a crop share, tenant farmers pay the landowner a proportion of their crop harvest in return for growing on the land with other farmers. Similarly, in an investment company, an investor pays the company fees for managing the fund in return for being able to pool their cash with other investors.

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Tell me more…

What is an investment company?

Investment companies are in the business of connecting investors with securities. They simplify the process of buying and selling stocks, bonds, mutual funds, companies, and other assets. When you invest with a firm, your money is pooled together with funds from several other investors. You share in the profits and losses in proportion to the funds you invested.

For example, let’s say an investment company pooled and invested $100,000 from several different clients. If your contribution was $10,000, then your portion would be 10% of whatever profits or losses the investment made.

An investment company can be a large corporation, a partnership, or a limited liability company. Regardless of the business structure, the Securities and Exchange Commission (SEC) regulates their activities.

What are the types of investment companies?

Of all the investment options out there, there are only three types of investment companies in the US. According to federal law, every investment company falls into one of these categories:

  • Mutual funds (aka open-end companies)
  • Closed-end funds (aka closed-end companies)
  • UITs (aka unit investment trusts)

Each has its own set of characteristics, but there are some overlapping traits. For instance, an open-end company lets you buy redeemable shares in a mutual fund or UIT. Since they’re redeemable, you can sell your shares back to the fund or trust if you don’t want to own them anymore. A broker acting on behalf of the fund or trust could also buy them back from you.

In this instance, you don’t necessarily get to pick the sale price, and you may have to sell them for less than you paid. The sale price typically depends on the net asset value (NAV) of the investment company whose shares you own. To get the NAV, you subtract the liabilities from the assets and then divide by the number of shares. This number can change daily, which is why mutual funds and UITs generally calculate the NAV after the market exchange closes for the day.

Companies that are closed-end funds sell shares that aren’t redeemable, so they’re sold in a different manner. If you have closed-end shares that you want to sell, you must find another investor to buy them on the secondary market, such as a stock exchange.

How do investment companies work?

Investment companies are primarily in the business of investing, reinvesting, or trading securities. There are several types of investment products a company can offer. Common examples are stocks, bonds, money market funds, index funds, and exchange-traded funds (ETFs).

An investment firm pools together money from multiple investors and spreads the risk by investing the pooled money across several types of assets. Professional fund managers look after the investments and make decisions that best optimize risk and return according to the investment objectives.

The choices a fund manager makes depend on the fund’s goals and risk tolerance. If you want to take a more aggressive approach, your investment dollars would need to be put into a fund that focuses on growth. For more stability and predictability in your returns, you’d likely opt for a separate, more conservative fund such as one that focuses on investments that pay dividends.

In an investment company, the investment objective is set for everyone, and there is no customization. So, if you choose to change your investment strategy over time, you will need to get into a different fund altogether.

Why should I choose an investment company?

Investing can present opportunities to grow your money, but it can also result in losing money. By choosing an investment company, you can tap into the expertise of an investment advisor, and seek to benefit from their years of experience balancing risk and reward. All investments, however, carries risk; no investment advisor or company can guarantee high returns or no risk of losses.

You could manage your portfolio on your own. This will give you a tremendous amount of freedom to implement any investment strategy that works for you. It might also save you money on fees.

However, you would need to learn about, and have a sound grasp of investing principles such as portfolio construction, risk tolerance, market cycles as well as the different asset classes. This can be done and may be enjoyable for some, but it would take a significant investment of time vs. paying someone else.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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