Investment fund


An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group such as reducing the risks of the investment by a significant percentage. These advantages include an ability to:
It remains unclear whether professional active investment managers can reliably enhance risk adjusted returns by an amount that exceeds fees and expenses of investment management. Terminology varies with country but investment funds are often referred to as investment pools, collective investment vehicles, collective investment schemes, managed funds, or simply funds. The regulatory term is undertaking for collective investment in transferable securities, or short collective investment undertaking. An investment fund may be held by the public, such as a mutual fund, exchange-traded fund, special-purpose acquisition company or closed-end fund, or it may be sold only in a private placement, such as a hedge fund or private equity fund. The term also includes specialized vehicles such as collective and common trust funds, which are unique bank-managed funds structured primarily to commingle assets from qualifying pension plans or trusts.
Investment funds are promoted with a wide range of investment aims either targeting specific geographic regions or specified industry sectors. Depending on the country there is normally a bias towards the domestic market due to 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.

History

The first professionally managed investment funds or collective investment schemes, such as mutual funds, were established in the Dutch Republic. Amsterdam-based businessman Abraham van Ketwich is often credited as the originator of the world's first mutual fund.

Law

The term "collective investment scheme" is a legal concept deriving initially from a set of European Union Directives to regulate mutual fund investment and management. The Undertakings for Collective Investment in Transferable Securities Directives , as amended by and created an EU-wide structure, so that funds fulfilling its basic regulations could be marketed in any member state. The basic aim of collective investment scheme regulation is that the financial "products" that are sold to the public are sufficiently transparent, with full disclosure about the nature of the terms.
In the United Kingdom, the primary statute is the Financial Services and Markets Act 2000, where Part XVII, sections 235 to 284 deal with the requirements for a collective investment scheme to operate. It states in section 235 that a "collective investment scheme" means "any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income".

Structure

Constitution and terminology

Collective investment vehicles may be formed under company law, by legal trust or by statute.
The nature of the vehicle 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 board of directors or trustees who safeguard the assets and ensure compliance with laws, regulations and rules.
  • The shareholders or unitholders who own the assets and associated income.
  • A "marketing" or "distribution" company to promote and sell shares/units of the fund.
Please see below for general information on specific forms of vehicles in different jurisdictions.

Net asset value

The net asset value is the value of a vehicle's assets minus the value of its liabilities. The method for calculating this varies between vehicle 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 in an initial public offering or through private placement. If shares are issued through an IPO, they are then traded on a stock exchange. or directly through the fund manager to create a secondary market subject to market forces.
The price that investors receive for their shares may be significantly different from net asset value ; it may be at a "premium" to NAV or, more commonly, at a "discount" to NAV.
In the United States, at the end of 2018, there were 506 closed-end mutual funds with combined assets of $0.25 trillion, accounting for 1% of the U.S. industry.

Exchange-traded funds

Exchange-traded funds combine characteristics of both closed-end funds and open-end funds. They are structured as open-end investment companies or UITs. ETFs are traded throughout the day on a stock exchange. An arbitrage mechanism is used to keep the trading price close to net asset value of the ETF holdings.
At the end of 2018, there were 1,988 ETFs in the United States with combined assets of $3.3 trillion, accounting for 16% of the U.S. industry.

Unit investment trusts

Unit investment trusts are issued to the public only once when they are created. UITs generally have a limited life span, established at creation. Investors can redeem shares directly with the fund at any time or wait to redeem them upon the trust's termination. Less commonly, they can sell their shares in the open market.
Unlike other types of mutual funds, unit investment trusts do not have a professional investment manager. Their portfolio of securities is established at the creation of the UIT.
In the United States, at the end of 2018, there were 4,917 UITs with combined assets of less than $0.1 trillion.

Gearing and leverage

Some collective investment vehicles 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 vehicle 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 split capital investment trust debacle in the UK in 2002.

Availability and access

Collective investment vehicles vary in availability depending on their intended investor base:
  • Public-availability vehicles are available to most investors within the jurisdiction they are offered. Some restrictions on age and size of investment may be imposed.
  • Limited-availability vehicles are limited by laws, regulations, and/or rules to experienced and/or sophisticated investors and often have high minimum investment requirements.
  • Private-availability vehicles may be limited to family members or whoever set up the fund. They are not publicly traded and may be arranged for tax or estate-planning purposes.

    Limited duration

Some vehicles 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 vehicles 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 a stockbroker or financial adviser with an initial commission ; such a class might be called retail shares.
  • Another class may be sold with no commission direct to the public; such a class is called direct shares.
  • Still a third class might have a high minimum investment limit and only be open to financial institutions; such a class is called institutional shares.
In some cases, by aggregating regular investments by many individuals, a retirement plan may qualify to purchase "institutional" shares even though no members of the plan would qualify individually.
Some of the fund classes:

Diversity and risk

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