Indirect Investment: Definition and Types

Indirect Investment Definition
Indirect Investment Definition and Types

Indirect investment is investment done through intermediaries. Indirect investment is designed to make investing easier for the retail investor. The need for indirect investment comes from the difficulty of investing directly in security. 

Let us take the case of stocks, for example. You can invest in stocks directly. But this often requires more work and market knowledge as you have to choose the stocks according to your investment needs and risk appetite, then design a portfolio according to the same. But your job doesn’t end there as well. You have to regularly monitor your portfolio to ensure its direction is right throughout the course of the investment. While all these are doable, it tends to demand much more from an investor. Indirect investment is a simple alternative for this. There will be a portfolio prebuilt by experts, and your job is to invest according to your preferences. Picking the securities, designing the portfolio, and even monitoring the same are done by experts.

The most common example of an indirect investment option is mutual funds. Mutual funds are pooled investments from several investors which are invested in a portfolio according to a theme.

There are two types of indirect investment in general – active and passive investments. Active investments are those that are actively managed by an expert. Hence, they come with a higher management charge (expense ratio) as well. On the other hand, passive investment is when the investment option’s portfolio is based on a preset composition, like a stock market index. A stock market index is a composition of the top stocks of a stock market or a sector. 

Let us learn in-depth about indirect investments, their types, advantages, and disadvantages through this article. 

What is Indirect Investment?

Indirect investment is when an investor chooses to invest in an instrument through an intermediary than directly. Investors choose indirect investment mainly to make investing easier. One of the hardest jobs for an active investor is to create a portfolio. A portfolio is the collection of securities that an investor holds. This has to be designed with ultimate precision to ensure it always matches your investment taste and theme. This is because securities, especially the ones that are market-linked, tend to be volatile, and the same can cause them to change characters as well. 

For instance, you could invest in a share because of the low risk it comes with. But due to market changes, this character of the share could change. You may miss this change if you are not on the lookout for the same at all times. Indirect investment is a solution for this. Here, instead of the investor, an expert takes care of the portfolio for a small fee. 

How does Indirect Investment work?

An indirect investment work by providing a portfolio for the investors to invest in. Let us take an example to understand this further.

One of the most common indirect investment options is mutual funds. Fund houses create mutual funds and appoint fund managers. Every fund will have a theme that they closely follow. The manager then creates a portfolio according to this theme. For instance, there will be more equity presence in the portfolio if the fund’s theme is aggressive. Investors who have an investment horizon that matches the theme of the fund will be interested. The fund manager then pools money from these investors and invests their money in the portfolio.

The working of all indirect investments is similar to the case above. Ultimately, the aim of an indirect investment is to make investing easier.

But how do the fund houses earn from this? They charge a fee from the investors called an expense ratio. An expense ratio is a percentage of the asset that is managed by the fund. In other words, it is a small percentage of your total investment. For instance, if you have invested Rs.100,000 and the expense ratio is 1%, then you will be charged Rs.1000. 

The expense ratio is chargeable per annum. Investors have to vary in higher expense ratios as they could eat into your returns. Hence, research is a must when choosing an indirect form of investment as well. 

What are the different types of Indirect Investment?

There are different types of indirect investments you can choose from according to your investment goals.

different types of Indirect Investment
Different types of Indirect Investment

Below is a list of six indirect investment types.

1. Mutual funds

Mutual funds are the most popular form of indirect investment. But the working of a mutual fund is simple. A mutual fund is a form of investment where investors can invest in a preset portfolio. This portfolio is built according to a theme. For instance, the portfolio will have more equity presence if the theme of the portfolio is aggressive. Mutual funds invest in different securities like stocks, debts, commodities, currencies, etc. The fund manager, who is appointed to manage the fund, will create a portfolio according to the theme.

Mutual funds give investors an option to invest easily. An investor’s job when investing in a mutual fund is limited to finding a fund that suits their goals. Mutual funds also don’t require regular intervention or monitoring most of the time. 

The biggest advantage of investing in a mutual fund is the ease of investing. The downside is the expense ratio that comes with it. A higher expense ratio could eat into the returns that mutual funds give. 

2. Insurance policies

An insurance policy is a contract between a policyholder and an insurer that underlines the payout the insurer has to provide in certain cases in lieu of regular or one-time payment from the insurer. The policyholder is the person who takes the insurance policy, and the insurer is the company that provides the insurance policy. Insurance policies are taken to insure a person under certain circumstances. For example, term insurance provides a payout in case of the demise of the insured during the period of the insurance. It is a way to secure one’s family and themselves against unforeseen circumstances.

Insurance policies are primarily meant for financial protection, but they often dual as an investment option too. In this case, a part of the investment you make goes for the insurance, and the rest is invested. This investment is made towards a prebuilt portfolio which the investor can choose, making insurance policies an indirect form of investment as well. 

Lower risk is the advantage of investing in insurance policies. But these are made for investment purposes first and may lack some features. 

3. Annuities

An annuity is an indirect investment option provided by insurance companies. An annuity is used to ensure regular earnings post-retirement. Investors are required to make either regular payments or a lump sum payment, and they will get regular income once the investment matures. 

Retirement investing is critical an annuity is an indirect investment option that can help you with the same. The regular payments that an investor gets post-retirement are helpful in tackling regular expenses once the regular income from a job or career stops after retirement.

Annuity investment options also invest in a prebuilt portfolio that helps you grow your investment, making annuity another beneficial indirect investment.

4. Unit investment trusts

A Unit Investment Trust (UIT) is an investment option that gives investors a fixed portfolio that consists of different securities, including stocks, bonds, money market instruments, etc. UITs are designed to give investors either capital appreciation or regular returns. Investors can make a choice in investing according to their goals. 

One thing that differentiates UITs and other similar investment options is the expiry date. Each investment in UIT will have a preset expiry date. Once it expires, the investor will get a cut of the profit. 

The advantage of investing in UITs is that it is predictable. At the same time, the non-dynamic nature of the same is a disadvantage. 

5. Open-ended funds

Open-ended funds are those options where new investors can invest even after the initial offering. Open-ended funds can issue an unlimited number of units after the first allotment. The fund house sells the units directly to the investors and buys them as well. They are not traded on stock exchanges and hence are less volatile.  

Their biggest advantage is higher liquidity. You can redeem the units at any time to cash the same. But open-ended funds tend to carry a higher market risk than close-ended funds. 

6. Close-ended funds

Close-ended funds are those mutual funds that only offer a fixed number of units. Investing in close-ended funds is limited, and they are tradable in the stock market. If a new investor needs to invest in a close-ended fund, they have to buy it from an existing investor who is looking to sell. However, this process is automated, similar to the case of stock investments. 

Since these are tradable in the stock market, their units’ prices could fluctuate more. At the same time, close-ended funds could run into liquidity issues on rare occasions. 

What are the advantages of Indirect Investment?

Indirect investments have three major advantages. Firstly, it makes investing easier. If an investor wants to manually invest in a security, they need to have a higher-level of market knowledge. This is needed so that the investor can do the research and find the options that suit their investment options and risk appetite. But with an indirect investment like mutual fund, the investing is easy as your job is limited to finding an option that suites you. The option usually comes with a portfolio that matches its theme. 

Secondly, it makes monitoring easy. In the case or regular investing, you have to have to be on your toes monitoring your investment options regularly. But when you choose indirect investment, an expert will take care of the monitoring part as well.

Lastly, indirect investment has higher liquidity as well. For instance, you will have to sell each security individually if you choose to invest in the regular way. But with an indirect investment, you can sell the units at once. 

What is the disadvantage of Indirect Investment?

The main disadvantage of indirect investment is bias. Bias is with human. Since your funds are managed by an investment expert in the case of indirect investment, the fund manager’s bias could affect the investment choices, even if the same is not intended. 

One way to mitigate this is by investing in passive funds. Passive funds invest in portfolios that track a particular composition like an index. A stock market index is a composition of the top stocks of a stock market or a sector. Hence, the portfolio’s composition will be same as the index’s and there is not need for the manager to make choices. This reduces the bias that indirect investments have.

Secondly, indirect investments could come with a handling charge. In the case of mutual funds, the fee is called an expense ratio. Expense ratio is usually a percentage of your total investment. For instance, the fee chargeable is Rs.1000 if the expense ratio is 1% and your investment is Rs.100,000. This fee can be avoided if you invest regularly in a fund. 

The best way to mitigate this is by investing by thoroughly doing your research and choosing an investment option with lesser expense ratio. Similar to the case of bias, passive funds could prove to be a solution as they come with a lesser expense ratio as well. 

Is investing in stock indirect investment?

Investing in stocks is not an indirect form of investment. Stock investment is tradional investing as you have to do the research and invest without the help of an intermediary. At the same time, investing in stocks through an option like mutual fund is an indirect form of investment. What is the Stock Market? Definition, Types and Significance for Investors must be known before investing.

Investors can make a choice between traditional and indirect investment here according to their investment goals and level of expertise. For example, if you have the expertise level to pick stocks, time the investments and then monitor the same, you may choose stock investments.

Is it more profitable to invest in Indirect Investment?

There profit an investor can get from indirect and regular investment is completely dependent on the methods used and market behavior during the course of investment. Hence, it is impossible to compare the two options. At the same time, both options are profitable if invested right. 

What is the difference between Direct and Indirect Investment?

Direct investment is another name for foregin direct investments. A firect investment or FDI is an investment made by an entity based on one country in another country. But the term direct investment is often confused for investing directly in securities instead of choosing an indirect investment option like mutual fund. 

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