What are investment funds?
Simple explanation about investment funds
1.- What are investment funds?
investment funds arecollective investment vehicles, in which they can participate bothprivate investors as well as institutional investors. There are many types of investment funds based on the classification of the Association of Collective Investment Institutions (INVERCO) and the National Securities Market Commission (CNMV). This article focuses on equity investment funds.
2.- Operation of investment funds and their types
A variable number of investors, called unit-holders, make contributions to the fund with the purpose of obtaining a positive return. In most cases, contributions are made once a month, although they can also be single contributions. The fund is created by an entity, the manager, which is the one that jointly invests these contributions in different financial assets following guidelines set beforehand.
There are basically two types of funds:actively managed fundsand thepassive management funds.
2.1.- Actively managed funds
In actively managed funds, the manager hires a manager, who is in charge of managing the money and whose task is to skillfully invest that money in order to obtain a return greater than that of the reference index. This manager generally has a team that helps him with the evaluation work in search of good investments. The fund's profitability depends directly on the operations carried out by its manager. The asset classes in which the manager can invest are determined by the type of fund and by a regulation to which he has to comply. Equity funds invest mainly in shares. The fund can therefore be understood as a large basket with many shares. Both the fund manager and the manager do not work for free but are paid through the commissions implicit in the value of the fund. Areimplicit commissionsin the value of the fund are those that form part of theTotal Expense Ratio (TER). In addition to the TER, the depositary institution or financial intermediary also usually chargesother explicit commissionsto fund value callssubscription fees, which are usually between 1 and 5% of the contributions, andredemption fees.
All the characteristics of the fund (implicit commissions, explicit commissions, investment policy, possibility of withdrawing the money, risk assumed, time horizon,...), are included in a document called the informative brochure and in the summary of the same calledDFI (Fundamental Information for the Investor). Each manager is required by law to make available to the public an updated information brochure with the characteristics of each fund.
What happens if the management company goes bankrupt?There is nothing to worry about, becausethe assets of the fund are not part of the balance sheet of the management company. The participants remain the owners of their capital. The manager only deals with the management and administration of the fund. For this reason, if a managing entity goes bankrupt, its assets would become dependent on another managing entity under the supervision of the Ministry of Economy. This is easier to understand with an example, imagine that you buy a property and hire a real estate agent who takes care of the rental of the property and all the activities that this entails. If the real estate agent goes bankrupt, you still own the property. You just have to deal with finding a new real estate agent. The same also applies in the case of bankruptcy of the depository entity.
2.2.- Passive management funds
Passively managed funds are intended toreplicate indices.
Within the passive management investment funds, the first to appear are theindex fundsor also calledindex funds. These funds replicate the index as closely as possible. To do this, they buy the assets that make up the indices in the same proportion that appear in the index. It is only necessary to carry out adjustment operations when a value within the index changes or the values change proportion. That is why the manager does not have the need to hire a manager and his team to evaluate the market in search of the best investments, since in this type of funds this is no longer necessary.
Another type of passive management investment funds aretraded fundseitherETFsby the English acronym ofExchange Traded Fund. These funds are also intended to replicate indices. At first you may think that they are identical to index funds but there are important differences between the two. ETFs combine the advantages of index funds along with the advantages of shares, since they trade just like shares do, this allows you to buy and sell them at any time during the Stock Market session. On the contrary, index funds are not listed on any market and their purchase or sale price is the liquidation value at the end of the Stock Market session. ETFs are an excellent way to invest in the stock market with a high degree of diversification at costs that are generally much lower than any other type of investment fund.
3.- Differences between investment funds and direct investments
We now turn to see the differences between investment funds and direct investments. Adirect investmentis ainvestment in a stock, real estate or in abondwithout going through an investment fund.
The first difference is explained quite well if we return to the example of the property. To buy a property you usually need a lot of money. To invest in an investment fund, in most cases only €50 per month is necessary in the form of a savings plan. Theinitial difficultyit is clearlymuch less.
Being a collective investment, theheritageavailable by fund ismuch older. Therefore, larger and more profitable investments can be made. For example, an investment fund can buy an office building that would not be possible for most private investors.
Also, theriskis usually ostensiblymuch less. An investment fund invests between 20 and 1,000 companies at a time, which causes adiversificationof risk.
Another positive point of investment funds is that they areregulated and supervisedby the CNMV. The funds are regulated by regulations that set limits to the way in which the management company can invest the money, in order to ensure a minimum level of diversification, liquidity and transparency. The managers also impose their own rules, such as a maximum of 20% in shares or a minimum of money reserves. In the information brochure of each investment fund you can find these internal regulations or internal investment policies.
To conclude, it can also be said that themanagersinvestment funds as well as their work teams normally havemany years of experience.
Of course, those who have a lot of time, money and experience can earn more money with direct investments, since they do not have to distribute the profits among the participants and do not have to pay management fees.