Types of Investment Vehicles

Why This Matters

When you're tested on investment vehicles, you're really being tested on your understanding of the risk-return tradeoff, liquidity, and ownership structures that define modern financial markets. Each vehicle represents a different answer to the fundamental question: How do investors balance the desire for returns against their tolerance for risk and need for access to their money? Understanding these tradeoffs is essential for portfolio construction, asset allocation, and advising clients—all core competencies in investments.

The vehicles covered here demonstrate key principles including diversification benefits, active versus passive management, direct versus pooled ownership, and the role of derivatives in hedging and speculation. Don't just memorize what each investment is—know what concept each vehicle illustrates and how it compares to alternatives. If an exam question asks about liquidity, you should immediately think of multiple vehicles ranked by how quickly they convert to cash. That's the level of conceptual thinking that separates strong answers from average ones.

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Equity Ownership Vehicles

These investments represent actual ownership stakes in companies or assets. When you own equity, you participate directly in the upside (and downside) of the underlying business or property.

Stocks

• Ownership claim on a corporation—stockholders are residual claimants, meaning they get paid after all other obligations are met
• Common vs. preferred distinction matters for exams: common stock carries voting rights and variable dividends, while preferred stock has fixed dividends and priority in liquidation
• Price volatility reflects market risk; prices respond to systematic factors (economy-wide) and unsystematic factors (company-specific)

Real Estate Investment Trusts (REITs)

• Pooled real estate ownership without direct property management—investors gain exposure to income-producing properties through shares
• 90% distribution requirement makes REITs attractive for income investors; this tax structure is frequently tested
• Liquidity varies significantly—publicly traded REITs offer stock-like liquidity, while private REITs may have redemption restrictions

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Debt Instruments

Debt securities represent loans to issuers. Investors become creditors rather than owners, receiving contractual interest payments in exchange for lower risk exposure.

Bonds

• Fixed-income securities with contractual coupon payments and principal repayment at maturity—the bondholder is a creditor, not an owner
• Inverse relationship with interest rates is critical: when market rates rise, existing bond prices fall (and vice versa), expressed as $P = \sum_{t=1}^{n} \frac{C}{(1+r)^t} + \frac{FV}{(1+r)^n}$
• Credit risk and duration determine bond volatility; government bonds carry less default risk than corporate bonds

Certificates of Deposit (CDs)

• Time deposits with fixed rates—the investor commits funds for a specific term in exchange for guaranteed interest
• FDIC insurance up to $250,000 makes CDs among the safest investments available; this protection is a key differentiator
• Early withdrawal penalties reduce liquidity; CDs sacrifice access for certainty of return

Money Market Accounts

• Hybrid savings vehicles offering higher yields than regular savings with limited transaction capabilities
• High liquidity with modest returns—typically invest in short-term, high-quality debt instruments
• Not FDIC-insured in all cases—money market funds differ from money market accounts at banks; know the distinction

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Pooled Investment Vehicles

These structures aggregate capital from multiple investors to achieve diversification and professional management. Pooling reduces transaction costs and provides access to strategies individual investors couldn't implement alone.

Mutual Funds

• Professionally managed portfolios where investors buy shares representing proportional ownership of the fund's holdings
• NAV pricing once daily—shares are bought and sold at the net asset value calculated after market close, not in real-time
• Active management fees (expense ratios) reduce returns; the average actively managed fund underperforms its benchmark after fees

Exchange-Traded Funds (ETFs)

• Trade intraday like stocks—this is the key structural difference from mutual funds, enabling real-time price discovery and tactical trading
• Generally lower expense ratios than mutual funds due to passive management and tax efficiency from the creation/redemption mechanism
• Track indices, sectors, or commodities—ETFs democratized access to asset classes previously difficult for retail investors to reach

Index Funds

• Passive replication strategy—designed to match, not beat, a benchmark index like the S&P 500
• Minimal management fees since no active security selection is required; this cost advantage compounds significantly over time
• Broad diversification automatically—a single S&P 500 index fund provides exposure to 500 large-cap U.S. companies

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Derivative Instruments

Derivatives derive their value from underlying assets. They can magnify returns through leverage but carry substantial risk—understanding their mechanics is essential for risk management questions.

Options

• Right without obligation to buy (call) or sell (put) an underlying asset at a strike price before expiration
• Leverage amplifies outcomes—a small premium controls a larger position, creating potential for outsized gains or total loss of premium
• Used for hedging or speculation—protective puts limit downside; covered calls generate income; naked options are highly speculative

Futures

• Binding contracts obligating both parties to transact at a specified price on a future date—unlike options, there's no choice at expiration
• Marked to market daily—gains and losses settle each day, requiring margin maintenance and creating cash flow volatility
• Leverage through margin means small price movements create large percentage gains or losses; this is why futures carry significant risk

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Quick Reference Table

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Self-Check Questions

1. Which two investment vehicles offer pooled diversification but differ in how they're priced and traded throughout the day?

2. Explain how the risk-return profiles of stocks and bonds differ, and identify which type of investor might prefer each.

3. Compare and contrast options and futures: What fundamental structural difference determines whether the holder has flexibility at expiration?

4. If a client needs guaranteed principal protection with a fixed return and can lock up funds for two years, which vehicles would you recommend and why?

5. An FRQ asks you to explain why index funds have grown in popularity relative to actively managed mutual funds. What two key factors should your response emphasize?