Investment fund

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A collective investment scheme is a way of investing money with others to participate in a wider range of investments than feasible for most individual investors, and to share the costs and benefits of doing so.

Terminology varies with country but collective investment schemes are often referred to as mutual funds, investment funds, managed funds, or simply funds (note: mutual fund has a specific meaning in the US). Around the world large markets have developed around collective investment and these account for a substantial portion of all trading on major stock exchanges.

Collective investments are promoted with a wide range of investment aims either targeting specific geographic regions (e.g. Emerging Europe) or specified themes (e.g. Technology). Depending on the country there is normally a bias towards the domestic market to reflect national self-interest as perceived by policy makers, familiarity and the lack of currency risk. Funds are often selected on the basis of these specified investment aims, their past investment performance and other factors such as fees.

Contents

Constitution and terminology

Collective investment schemes may be formed under company law, by legal trust or by statute.

The nature of the scheme and its limitations are often linked to its constitutional nature and the associated tax rules for the type of structure within a given jurisdiction.

Typically there is:

  • A fund manager or investment manager who manages the investment decisions.
  • A fund administrator who manages the trading, reconciliations, valuation and unit pricing.
  • A trustee or board who safeguards the assets and ensures compliance with the laws and rules.
  • The shareholders or unitholders who own (or have rights to) the assets and associated income.
  • A "Marketing" or "Distribution" company to promote and sell the fund.

Please see below for general information on specific forms of scheme in different jurisdictions.

Net asset value

The Net Asset Value or NAV is the value of a scheme's assets less the value of its liabilities. The method for calculating this varies between scheme types and jurisdiction and can be subject to complex regulation.


Open-end fund

An open-end fund is equitably divided into shares which vary in price in direct proportion to the variation in value of the fund's net asset value. Each time money is invested, new shares or units are created to match the prevailing share price; each time shares are redeemed, the assets sold match the prevailing share price. In this way there is no supply or demand created for shares and they remain a direct reflection of the underlying assets.

Closed-end fund

A closed-end fund issues a limited number of shares (or units) in an initial public offering (or IPO). The shares are then traded on an exchange or directly through the fund manager to create a secondary market subject to market forces. If demand for the shares is high, they may trade at a premium to net asset value. If demand is low they may trade at a discount to net asset value. Further share (or unit) offerings may be made by the scheme if demand is high although this may affect the share price.

The added element of market forces tends to amplify the performance of the fund increasing investment risk through increased volatility.

Gearing and leverage

Some collective investment schemes have the power to borrow money to make further investments; a process known as gearing or leverage. If markets are growing rapidly this can allow the scheme to take advantage of the growth to a greater extent than if only the subscribed contributions were invested. However this premise only works if the cost of the borrowing is less than the increased growth achieved. If the borrowing costs are more than the growth achieved a net loss is achieved.

This can greatly increase the investment risk of the fund by increased volatility and exposure to increased capital risk.

Gearing was a major contributory factor in the collapse of the investment trust debacle in the UK in 2002. [1]

Availability and access

Collective investment schemes vary in availability depending on their intended investor base.

  • Public Schemes - are available to most investors within the jurisdiction they are offered. Some restriction on age and size of investment may be imposed.
  • Limited availability schemes - are limited by regulation or scheme rules to experienced investors and often have high minimum investment requirements. Hedge funds are often restricted this way.
  • Private schemes - may be limited to family members or whoever set up the fund. They are not publicly quoted and often are arranged for tax or estate planning purposes. A private equity fund is an example of this type of arrangement.

Limited duration

Some schemes are designed to have a limited term with enforced redemption of shares or units on a specified date.

Unit or Share Class

Many collective investment schemes split the fund into multiple classes of shares or units. The underlying assets of each class are effectively pooled for the purposes of investment management, but classes typically differ in the fees and expenses paid out of the fund's assets.

These differences are supposed to reflect different costs involved in servicing investors in various classes; for example:

  • One class may be sold through broker or financial adviser with an initial commission (front-end load) and might be called retail shares.
  • Another class may be sold with no commission (load) direct to the public called direct shares.
  • Still a third class might have a high minimum investment limit and only be open to financial institutions, and called institutional shares.

In some cases, by aggregating regular investments by many individuals, a retirement plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the benefit of their typically-lower expense ratios) even though no members of the plan would qualify individually.

Generic information - advantages

Diversity and risk

One of the main advantages of collective investment is the reduction in investment risk (capital risk) by diversification. An investment in a single equity may do well, but it may collapse for investment or other reasons (e.g., Marconi Corporation plc, Enron). If your money is invested in such a failed holding you could lose your capital. By investing in a range of equities (or other securities) the capital risk is reduced.

  • The more diversified your capital, the lower the capital risk.

This investment principle is often referred to as spreading risk.

Collective investments by their nature tend to invest in a range of individual securities. However, if the securities are all in a similar type of asset class or market sector then there is a systematic risk that all the shares could be affected by adverse market changes. To avoid this systematic risk investment managers may diversify into different non-perfectly-correlated asset classes. For example, investors might hold their assets in equal parts in equities and fixed income securities.

Reduced dealing costs

If one investor were to buy a large number of direct investments, the amount they would be able to invest in each holding is likely to be small. Dealing costs are normally based on the number and size of each transaction, therefore the overall dealing costs would take a large chunk out of the capital (affecting future profits). Pooling money with that of other investors gives the advantage of buying in bulk, making dealing costs an insignificant part of the investment.

Generic information - disadvantages

Costs

The fund manager managing the investment decisions on behalf of the investors will of course expect remuneration. This is often taken directly from the fund assets as a fixed percentage each year or sometimes a variable (performance based) fee. If the investor managed their own investments, this cost would be avoided.

Often the cost of advice given by a stock broker or financial adviser is built into the scheme. Often referred to as commission or load (in the U.S.) this charge may be applied at the start of the plan or as an ongoing percentage of the fund value each year. While this cost will diminish your returns it could be argued that it reflects a separate payment for an advice service rather than a detrimental feature of collective investment schemes. Indeed it is often possible to purchase units or shares directly from the providers without bearing this cost.

Lack of choice

Although the investor can choose the type of fund to invest in, they have no control over the choice of individual holdings that make up the fund.

Loss of owner's rights

If the investor holds shares directly, they may be entitled to shareholders' perks (for example, discounts on the company's products) and the right to attend the company's annual general meeting and vote on important matters. Investors in a collective investment scheme often have none of the rights connected with individual investments within the fund.

Style

Investment aims and benchmarking

Each fund has a defined investment goal to describe the remit of the investment manager and to help investors decide if the fund is right for them. The investment aims will typically fall into the broad categories of Income (value) investment or Growth investment. Income or value based investment tends to select stocks with strong income streams, often more established businesses. Growth investment selects stocks that tend to reinvest their income to generate growth. Each strategy has its critics and proponents; some prefer a blend approach using aspects of each.

Funds are often distinguished by asset-based categories such as equity, bonds, property, etc.

Also, perhaps most commonly funds are divided by their geographic markets or themes.

Examples

  • The largest markets - U.S., Japan, Europe, United Kingdom and Far East are often divided into smaller funds e.g. US large caps, Japanese smaller companies, European Growth, UK mid caps etc.
  • Themed funds - Technology, Healthcare, Socially responsible funds

In most instances whatever the investment aim the fund manager will select an appropriate index or combination of indices to measure its performance against; e.g. FTSE 100. This becomes the benchmark to measure success or failure against.

Global Investment Performance Standards (GIPS)

Key features of the Global Investment Performance Standards include the following:

  • The GIPS standards are ethical standards for investment performance presentation to ensure fair representation and full disclosure of investment performance. In order to claim compliance, firms must adhere to the requirements included in the GIPS standards.
  • Meeting the objectives of fair representation and full disclosure is likely to require more than simply adhering to the minimum requirements of the GIPS standards. Firms should also adhere to the recommendations to achieve best practice in the calculation and

presentation of performance.

  • The GIPS standards require firms to include all actual, discretionary, fee-paying portfolios in at least one composite defined by investment mandate, objective, or strategy in order to prevent firms from cherry-picking their best performance.
  • The GIPS standards rely on the integrity of input data. The accuracy of input data is critical to the accuracy of the performance presentation. The underlying valuations of portfolio holdings drive the portfolio’s performance. It is essential for these and other

inputs to be accurate. The GIPS standards require firms to adhere to certain calculation methodologies and to make specific disclosures along with the firm’s performance.

  • Firms must comply with all requirements of the GIPS standards, including any updates, Guidance Statements, interpretations, Questions & Answers (Q&As), and clarifications published by CFA Institute and the GIPS Executive Committee, which are available on

the GIPS website (www.gipsstandards.org) as well as in the GIPS Handbook.

The GIPS standards do not address every aspect of performance measurement or cover unique characteristics of each asset class. The GIPS standards will continue to evolve over time to address additional areas of investment performance. Understanding and interpreting investment performance requires consideration of both risk and return. Historically, the GIPS standards focused primarily on returns. In the spirit of fair representation and full disclosure, and in order to provide investors with a more comprehensive view of a firm’s performance, the 2010 edition of the GIPS standards includes new provisions related to risk.

Active or passive management

The aim of most funds is to make money by investing in assets to obtain a real return (i.e. better than inflation).

The methods used to make your investment vary and two opposing views exist.

Active management - Active managers believe that by selectively buying within a market that it is possible to outperform the market as a whole. Therefore they employ dynamic portfolio strategies buying and selling investments with changing market conditions.

Passive management - Passive managers believe that it is impossible to predict which individual holdings or section of the market will perform better than another therefore their portfolio strategy is determined at outset of the fund and not varied thereafter. Many passive funds are index funds where the fund tries to mirror the market as a whole. Another example of passive management is the "buy and hold" method used by many traditional Unit Investment Trusts where the portfolio is fixed from outset.

An example of active management success

  • In 1998 Richard Branson (head of Virgin Group) publicly bet Nicola Horlick (head of SG Asset Management) that her SG UK Growth fund would not beat the FTSE 100 index, nor his Virgin Index Tracker fund over three years, nor achieve its stated aim to beat the index by 2% each year. He lost and paid £6,000 to charity.

Alpha, Beta, R-squared and standard deviation

When analysing investment performance, statistical measures are often used to compare 'funds'. These statistical measures are often reduced to a single figure representing an aspect of past performance:

  • Alpha represents the fund's return when the benchmark's return is 0.

This shows the fund's performance relative to the benchmark and can demonstrate the value added by the fund manager. The higher the 'alpha' the better the manager. Alpha investment strategies tend to favour stock selection methods to achieve growth.

  • Beta represents an estimate of how much the fund will move if its benchmark moves by 1 unit. This shows the fund's sensitivity to changes in the market. Beta investment strategies tend to favour asset allocation models to achieve outperformance.
  • R-squared is a measure of the association between a fund and its benchmark. Values are between 0 and 1. Perfect correlation is indicated by 1, and 0 indicates no correlation. This measure is useful in determining if the fund manager is adding value in their investment choices or acting as a closet tracker mirroring the market and making little difference. For example, an index fund will have an R-squared with its benchmark index very close to 1, indicating close to perfect correlation (the index fund's fees and tracking error prevent the correlation from ever equalling 1).
  • Standard deviation is a measure of volatility of the fund's performance over a period of time. The higher the figure the greater the variability of the fund's performance. High historical volatility may indicate high future volatility, and therefore increased investment risk in a fund.

Types of risk

Depending on the nature of the investment, the type of 'investment' risk will vary.

A common concern with any investment is that you may lose the money you invest - your capital. This risk is therefore often referred to as capital risk.

If the assets you invest in are held in another currency there is a risk that currency movements alone may affect the value. This is referred to as currency risk.

Many forms of investment may not be readily salable on the open market (e.g. commercial property) or the market has a small capacity and investments may take time to sell. Assets that are easily sold are termed liquid therefore this type of risk is termed liquidity risk.

Charging structures and fees

Fee types

There may be an initial charge levied on the purchase of units or shares this covers dealing costs, and commissions paid to intermediaries or salespeople. Typically this fee is a percentage of the investment. Some schemes waive the initial charge and apply an exit charge instead. This may be graduated disappearing after a number of years.

The scheme will charge an annual management charge or AMC to cover the cost of administering the scheme and remunerating the investment manager. This may be a flat rate based on the value of the assets or a performance related fee based on a predefined target being achieved.

Different unit/share classes may have different combinations of fees/charges.

Pricing models

Open-ended schemes are either dual priced or single priced.

Dual priced schemes have a buying (offer) price and selling or (bid) price. The buying price is higher than the selling price, this difference is known as the spread or bid-offer spread. The difference is typically 5% and may be varied by the scheme manager to reflect changes in the market; the amount of variation may be limited by the schemes rules or regulatory rules. The difference between the buying and selling price includes initial charge for entering the fund.

The internal workings of a fund are more complicated than this description suggests. The manager sets a price for creation of units/shares and for cancellation. There is a differential between the cancellation and bid prices, and the creation and offer prices. The additional units are created are place in the managers box for future purchasers. When heavy selling occurs units are liquidated from the managers box to protect the existing investors from the increased dealing costs. Adjusting the bid/offer prices closer to the cancellation/creation prices allows the manager to protect the interest of the existing investors in changing market conditions [2]

Most unit trusts are dual priced.

Single priced schemes notionally have a single price for units/shares and this price is the same if buying or selling. As single prices scheme can't adjust the difference between the buying and selling price to allow for market conditions another mechanism the dilution levy exists. SICAVs, OEICs and U.S. mutual funds are single priced.

A dilution levy can be charged at the discretion of the fund manager, to offset the cost of market transactions resulting from large un-matched buy or sell orders. For example if the volume of purchases outweigh the volume of sales in a particular trading period the fund manager will have to go to the market to buy more of the assets underlying the fund, incurring a brokerage fee in the process and having an adverse affect on the fund as a whole ("diluting" the fund). The same is the case with large sell orders. A dilution levy is therefore applied where appropriate and paid for by the investor in order that large single transactions do not reduce the value of the fund as a whole. [3]

Internationally recognised collective investments

  • Exchange-traded funds or ETFs - an open-ended fund traded by listed shares on major stock exchanges.
  • Real estate investment trust or REITs - a close-ended fund that invests in real estate.
  • Sovereign investment funds

US specific collective investments

(Click here for US SEC description of investment company types).

  • Mutual funds - Open-ended with a corporate or trust structure.
  • Closed-end funds - Closed-ended with corporate structure.
  • Unit investment trusts - Open-ended with a trust structure and limited duration.
  • Exchange-traded funds (ETFs) - Structured as mutual funds or unit investment trusts, but publicly traded.

UK specific collective investments

  • Investment trusts - Introduced 1868. Closed-ended with corporate structure.
  • Unit trusts - Introduced 1931. Open-ended with a trust structure.
  • With-profits policy - Open-ended with a life policy structure.
  • Unitised insurance fund - Introduced 1970s. Open-ended with a life policy structure.
  • OEICs or ICVCs - Introduced 1997. Open-ended with a corporate structure.
  • Exchange-traded funds (ETFs) - Open-ended with a corporate structure.

Canadian collective investments

  • Income trusts
  • Labour Sponsored Venture Capital Corporations
  • Mutual funds

Ireland specific collective investments

  • Common contractual fund

European collective investments

  • UCITS
  • SICAVs

France & Luxembourg

  • Investment funds
    • FCP (Fonds commun de placement) (unincorporated investment fund or common fund)
    • SICAF (Société d'investissement à capital fixe) (Investment company with fixed capital)
    • SICAV (Société d'investissement à capital variable) (Investment company with variable capital)

Netherlands and Belgium

    • BEVEK (Investment Company with variable capital)
    • BEVAK (Investment company with fixed capital)
    • PRIVAK (Closed-end investment company)

Ukraine

    • Institut sovmestnogo investirovania, ISI (Investment Funds)
      • Private investment fund (Paevoi invest fond)
      • Public investment fund (Korporativny invest fund)

Both funds are run by Investment Company (KYA - kompania upravlenia activami).Funds and companies regulated and supervised by DKTsPFR

Greek Mutual Funds

Some basic information about Greek Mutual Funds

We could say that a mutual fund is a pool of money which belongs to many investors. Otherwise a M/F is the common cashier of many investors who trust a third party to operate and manage their wealth. Moreover they order this third party which in Greece is called A.E.D.A.K. (Mutual Fund Management Company S.A.) to spread their money in many different investment products such as shares, bonds, deposits, repo etc. Those companies in Greece may provide services according to article 4 of Law 3283/2004. People who own units (shares) of a mutual fund are called unitholders. In Greece co-unitholders, which are persons participating in the same units of M/F have exactly the same rights as the unitholder (according to the Law for the deposits in common account 5638/1932).

The unitholders have to sign and accept the document which describes the purpose of the Mutual Fund, how it operates, and anything concerning the Fund. This document is the regulation of the M/F. The property of each M/F by law have to be under the control of a bank legally operating in Greece (Greek or foreign).

The bank is the custodian of the M/F and except of the custody of the fund also controls the lawfulness of all movements of the management company. The Supervisory and Regulatory Body of M.F. Management Companies and Portfolio Investment Companies is the Greek Capital Market Commission. It comes under the jurisdiction of the Ministry of National Economy and controls the operation of all M/Fs available in Greece.

All investors have to be very careful and about the risk they undertake. They have to have in mind that all investments have a certain degree of risk. Risk – free investments does not exist. You can find more about Greek Mutual Funds in the site of the ASSOCIATION OF GREEK INSTITUTIONAL INVESTORS www.agii.gr or the site of Greek (Hellenic) Capital Market Commission www.hcmc.gr .

Switzerland

  • open-ended
    • Anlagefonds (unincorporated investment fund or common fund)
    • SICAV (Société d'investissement à capital variable) (Investment company with variable capital)
  • closed-ended
    • SICAF (Société d'investissement à capital fixe) (Investment company with fixed capital)
    • Kommanditgesellschaft für Kapitalanlagen (Limited Partnership)

Australian collective investments

  • Listed investment company or LIC. Closed-ended collective investment either corporate or trust based. Available since 1928.
  • Unit trusts open-ended trust based investments often called Managed funds or unlisted managed funds.

Offshore collective investments

  • Segregated portfolio company a corporate entity for holding various investments under a single legal entity.

Varieties of investment funds

  • Closed-end fund
  • Exchange-traded fund
  • Financial intermediary
  • Financial planner
  • Fund derivative
  • Fund of hedge funds
  • Hedge fund
  • Independent financial adviser
  • Investment adviser
  • Investment management
  • Offshore investment
  • Open-end fund
  • Private equity fund
  • Global assets under management

References

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