Let’s start with the basics: what is commingling?
What is commingling?
Commingling, in securities investing, happens when money from several different investors is pooled into one fund. Imagine your broker’s accounts are like pockets; Smith’s invested funds go into one pocket, Jones’ funds into another. Commingling is when your broker empties all their pockets into the same big bag, stirring everyone’s money together.
In some cases people use the term “commingling” to refer to business owners mixing their business and personal incomes, which has obvious negatives for financial security and financial transparency, but this post discusses the securities and trading meaning of the term.
(It can also refer to an illegal act, using client money for purposes the client didn’t agree to, but that’s also not what we’re talking about here.)
Commingling is usually done because it has benefits including allowing access to economies of scale, lower fees and a wider range of investments.
How does Commingling work?
Nearly all investment funds use commingling, combining the assets of multiple investors into a single fund or investment vehicle. For example, if you deposited a paycheck into an inheritance fund, the check would become “a drop in the ocean” — no longer separate funds, it simply becomes part of the inheritance fund.
In investment management, commingled funds pool individual customer contributions into a fund which is part-owned by each contributor. These funds are then managed toward a specified objective. This is the fund structure used for mutual funds and institutional investment funds.
The benefits of commingling
Commingling lets portfolio managers manage entire funds according to investment strategies tailored to the fund, rather than managing each individual investment as its own fund. Trends can be executed in larger blocks, allowing managers to reduce trading costs per dollar (since larger trades are usually less expensive).
However, this arrangement does require fund managers to maintain certain positions in cash to account for the transactions of the commingled shareholders.
Standardized record-keeping lets operations teams monitor and report fund positions to investors, and daily price quotes let mutual fund investors follow their exact position in a mutual fund as a percentage of the fund’s total managed assets.
All types of commingled funds offer investors advantages of scale, meaning you’re likely to get a better return through a commingled fund than through an investment vehicle that keeps your invested funds separate.
Investors also pay smaller fees to their broker, because the broker’s fees are paid by the fund rather than individually. And commingled funds might have access to more investment opportunities, because a lower rate of return might still be worth attention if the sum invested is higher.
Types of commingled funds
Mutual and commingled funds are two of the most popular commingled vehicles; any fund that commingles investor contributions for a specified investment goal can be considered a commingled fund. Other types of commingled funds include exchange-traded funds, commingled trust funds, collective investment trusts, and real estate investment trusts.
Mutual funds
Mutual funds are open to both retail and institutional investors, and they’re open-ended and professionally managed. Managers guide the fund to the targets stated in the fund prospectus, and funds like this are a good way for retail investors to gain access to professionally-managed portfolios of stocks, bonds and securities and thus realize significantly higher returns.
They’re referred to differently around the world — in the USA, “mutual funds” is used, while in the UK, it’s “Open-Ended Investment Company” (OEIC). In the US, mutual funds have to be registered with the SEC; in the EU a mutual recognition agreement means funds based in any EU nation can be sold bloc-wide.
Commingled funds
Commingled funds are portfolios that contain assets belonging to several accounts, blended together and managed as a single fund. They’re set up for several reasons, including to reduce the cost of managing several accounts separately, and usually aren’t available to individual retail investors. They’re common in closed retirement plans, pension funds, insurance policies, and other institutional accounts.
Commingled funds are similar to mutual funds, in that they’re also managed professionally by fund managers. Both fund types invest in financial instruments including stocks, bonds, and combinations of both. And both benefit from economies of scale, allowing for lower trading costs per invested dollar, and diversification which reduces overall risk. But commingled funds don’t have tickers so it’s harder to get transparency on their returns, and they’re less regulated than mutual funds; a boon when reduced red tape means reduced drag on returns, but sometimes a potential problem too.
Exchange-Traded Funds (ETFs)
Exchange-Traded Funds were created in the 1990s as a lower-cost alternative to mutual funds, offering diversification, trading, and arbitrage options for investors. They were developed out of the indexed funds of the 1970s, designed to track the market, and by 2003 ETF investment flows exceeded those of conventional mutual funds.
Real Estate Investment Trusts (REITs)
These are commingled funds that allow individual investors to participate in large retail projects. REITs are usually operating companies that own and operate real estate assets like apartments, shopping centres, and office buildings. Shares are sold on public exchanges, and dividends come from the operation of the company that owns the asset.
Commingled trust funds
Commingled trust funds combine assets under a joint investment strategy, managed by a single entity, even if the assets are the legal property of more than one trust — or retirement plan. In the US, these are regulated by the Office of the Comptroller of the Currency (OCC) rather than the SEC. They function like a mutual fund, but with less transparency and oversight.
The risks of commingling
Commingling is one of the “risky practices” (along with rehypothecation) that Wall Street gets called out for. For the financial system, commingling reduces the likelihood of a trust or fund going bust, but it increases the extent of the losses if it ever does; it makes the financial system more responsive and liquid, but more prone to overcorrections and more exposed in the event of sudden changes of direction.
For individual investors, commingling increases returns, and gives retail investors access to professional management at an affordable cost; but it also means their capital can be at risk if other investors request redemptions (the return of invested capital) in sufficient numbers; sometimes one effect of this, even if the fund is so managed as to maintain liquidity, is “tail risk” — remaining investors are left with a concentrated, less-liquid pool of assets and the fund is depleted.
Despite the risks, commingled funds remain popular because of their many benefits to brokers, institutional and retail investors, and the financial system as a whole.
Commingling is possible with digital assets, but there the risks involved may be greater, because digital assets exist electronically and are hackable.
On-chain, their best-in-class cryptography protects them; move several investors’ digital holdings into a single, managed omnibus wallet and you create a honeypot that’s both accessible and tempting for bad actors.
This is in effect what happens on centralized exchanges (though exchanges aren’t in any sense managed funds) and hacking attacks on such exchanges have grown into a major danger.
However, technological and structural solutions to this danger exist, and while they have been pioneered by early-movers within the digital assets space, we can expect to see them spread to the traditional financial world as institutional money moves into digital assets.