Don’t know your hedge fund from your mutual fund?

Ever read the money or finance section of a newspaper and not known what on earth it is talking about? Investment banks, mutual funds, hedge funds, pension funds, credit rating agencies; just some of the terms that are always used but do we actually understand what they are? In this article we shall uncover and simplify their meanings.

An investment bank, traditionally, doesn’t accept deposits from and provide loans to individuals, unlike commercial banks. Although the repeal of the Glass Steagall Act in 1999 (designed to separate commercial and investment banking activities) has lead to many banks having both a depositary commercial side and also an investment banking side creating much controversy in recent years as we shall discover in later articles. So, this is one cause of confusion; many banks are both commercial and investment banks.

We all know what a commercial bank does, take deposits and provide us with loans such as mortgages, but let us now see what an investment bank actually does. Put simply an investment bank provides financial services to companies, governments and high-net worth individuals (the extremely rich!) An Investment bank helps governments, companies and other agents to raise money by selling securities (bonds, basically an IOU, and stocks, a portion of ownership in a company) in the primary market. They also assist in raising money for companies in the capital markets, through issuing both equity (shares) and debt (loans). They provide strategic advisory services for companies in mergers and acquisitions and other transactions. In simple terms they help companies raise money through providing them with their expertise, preparing all the necessary documents and ensuring all government regulation is adhered to. Some key players in the investment banking world are Goldman Sachs, Morgan Stanley, UBS and Barclays Capital.

Mutual funds are another financial institution that has grown in popularity over the past 20 years; in the US more than 80 million people invest in mutual funds. To understand what a mutual fund is it’s useful to think of it as a company which brings people together and invests their money in stocks, bonds and other securities. Each investor owns shares which represents how much of the holdings they own. The largest mutual funds in the world include Vanguard Group, Fidelity Investments and PIMCO Funds.

Another key financial institution that keeps popping up in the media is hedge funds. A hedge fund is a private investment fund that has a large, unregulated pool of capital that is controlled by experienced investors. They are usually used by wealthy individuals and institutions who provide the money for hedge funds to invest. Hedge funds use a wide range of sophisticated investment strategies in order to maximise returns such as hedging, leveraging and derivatives trading (to be discussed in later articles). Hedge funds are generally left unsupervised by national regulators and therefore do not have to conform to regulatory laws that other financial institutions such as mutual funds must, which has lead to aggressive investing strategies. Some of the biggest hedge funds in the world are BlackRock ($25.0 billion), Bridgewater Associates ($58.9 billion) and Soros Fund Management ($27.9 billion).

Another important fund to understand is a pension fund. Employers establish pension funds in order to pay their employees retirement benefits. The employee will make contributions to the fund by transferring part of their current income stream toward retirement income. The funds are then invested on the employee’s behalf in order to grow the fund steadily through low-risk investments allowing the employee to receive benefits once they retire.

As we have seen all of these financial institutions invest in stocks, bonds or other securities, but how do they decide where to invest? This is where rating agencies come into the picture. Along with other factors the rating of a security is one key element that investors take into consideration when investing. A rating agency is an independent firm that rates securities’ creditworthiness on behalf of investors. A security, let’s say a bond, is rated according to how safe it is from an investor’s point of view, this is based on the ability of the company or government (bond issuer) to repay the bond. A security with the best rating (AAA) will be seen as a low-risk investment whereas a security with the lowest rating (D) will be seen as a very risky investment, where there is a high chance of making a loss. There are three main rating agencies; Fitch, Moody’s and S&P. Their decisions to downgrade or upgrade a security can have considerable consequences for the financial markets. Most recently of course we have seen S&P downgrade the US’s credit rating from AAA (best rating) to AA+ in August 2011. This has lead to investor scepticism towards investing in US government bonds. On October 19th China, the largest buyer of US debt, sold $36.5bn in US Treasuries bonds, showing how influential rating agencies can be.