Characteristics of an investment fund

What is an investment fund?

An investment fund is a structure that allows a number of separate and unrelated investors, a group of individuals or companies, to make investments together. By pooling their investments, this allows them to share the costs and benefit from the advantages of investing larger amounts, including diversification among a number of different assets and spreading the risks. There are many possible variations in the way an investment fund is set up and operates, generally depending on the needs of the fund’s investors.

There is no fixed number of investors in a fund: investment funds can be created as a vehicle for a single investor, or can have thousands of investors. They can also be set up in different forms, for instance as a limited liability company with shareholders and a board of directors, or as a contractual arrangement between investors. Funds can be set up with an indefinite lifespan, or for a fixed period. They can hold mainstream financial assets such as shares and bonds, or investments as exotic as vintage wines, paintings or copyright rights. They can generate income for investors, or seek to maximise the capital value of its investments. They can be open for sale to any individual investor, or be restricted to sophisticated investors such as financial institutions and very wealthy families.

Luxembourg’s fund legislation covers many different kinds of fund, but the most important category is UCITS funds set up according to the strict rules prescribed by the European Union. UCITS funds can be bought by investors in any European country where they are registered for sale, as well as in other regions such as Asia. Luxembourg is home to nearly three-quarters of all European funds sold to investors in more than one country.

FCP v. SICAV

FCPs and SICAVs are two of the main types of fund created in Luxembourg and both can be set up as UCITS funds. FCP stands for the French expression ‘Fonds Commun de Placement’ and literally means a common investment fund. Like a unit trust in the UK, it is set up in the form of a contract between the manager of the fund and the investors, similar to a partnership, and is not a separate legal entity in its own right. Investors hold units in an FCP.

SICAV stands for ‘Société d’Investissement à Capital Variable’, or open-ended investment company, whose ownership is in the form of shares. This means that the amount of capital in the fund varies according to the number of investors and how much each of them has invested. As with an FCP, shares in a SICAV are bought and sold based on the value of the fund’s assets, or Net Asset Value. The SICAV must either appoint a management company in accordance with applicable law and regulations, or can be self-managed.

For individual investors there are few practical differences whether a fund is an FCP or a SICAV. However, there may be personal tax implications and you should consider this carefully with your financial advisor.

Accumulation v. distribution

Some investors want to receive regular income from their fund investments. However, others want to build up the value of their initial investments by reinvesting any profits in the investment fund. Therefore many funds offer a choice between distribution (or income) shares or units that pay out income (i.e. from bond interest or dividends), and accumulation shares or units that automatically reinvest income back into the fund.

An investment fund with distribution shares or units may be the right choice if you need extra income from your investments, while accumulation shares or units may be better if you are investing for a long-term goal such as retirement. Distribution shares or units may rise in value over time, but your investment will probably not grow as rapidly as an equivalent investment in accumulation shares or units.

In addition, the reinvestment of income through accumulation shares or units is usually free of charge. By contrast, if you took the income of the fund as a cash distribution and then used it to make new investments you might pay an initial charge to the manager of the fund of up to 5 per cent. Depending on the rules where you live, the tax treatment of distribution and accumulation shares or units may be different, and you should carefully consider this with your financial advisor.

Umbrella funds

Many Luxembourg investment funds are set up as so-called umbrella funds, which consist of multiple sub-funds or separate compartments within the overall fund structure that in effect operate as individual investment funds but form part of one single legal entity. This enables funds with different strategies or that are designed for different types of investor to be created within the same legal structure, which can reduce the funds’ costs. It’s usually less expensive for investors to switch investments from one fund to another if they are all part of the same umbrella fund, although there may be tax implications, depending upon your home country’s rules.

How a fund price is determined

The price of a unit (FCP) or a share (SICAV) in an open-ended investment fund is determined by the value of its assets and is measured as its Net Asset Value (NAV). The NAV is calculated as the market value of the fund’s assets, minus any liabilities such as expenses or other debt. This figure is then divided by the number of shares or units in the fund that have been issued to investors. For example, if a fund has assets valued at €100 million and liabilities of €5 million, it has net assets of €95 million. If 10 million shares or units are held by investors, its NAV per share or unit is €9.5. That is the price at which shares or units can be bought in the fund or sold back to it, subject to any fees and commission charges.

Understanding investment fund fees

Investors face various fees and charges when they buy and sell fund shares, and the investment fund itself will be subject to various fees that are paid out of the fund’s assets. Investment in funds often involves an initial charge that may be as much as 5 per cent of the value of the initial investment. This fee is not simply pocketed by the fund manager but may cover costs such as commission paid to fund distributors such as banks or other financial advisors. Some managers also charge fees when fund shares are sold or redeemed, especially where the shares have been held for a very short period of time.

The ongoing costs charged to the investment fund are usually measured as its Total Expense Ratio or TER. This comprises the fee paid to the fund management company for deciding on and managing the fund’s investments, as well as other costs involved in operating the fund. These include safekeeping of assets by the fund’s custodian, calculation of the Net Asset Value, legal services, auditing and marketing costs.

An important component of the investment fund’s costs will be the fee charged by the fund manager, which depends on the complexity of the fund’s investment strategy. This means that the TER of actively managed funds can be as high as 2 per cent or even more for very specialised or exotic funds. By contrast, the TER of a passive fund that aims to replicate a specific index is usually less than 1 per cent.

Understanding investment fund information

Information about an investment fund can be found from three different sources – marketing material (including the web site of the fund manager), the fund’s prospectus and its annual or semi-annual financial report. While each source is designed to provide investors with accurate information about the fund, they offer different types of information and in different ways. It is important to read all the available information and discuss it with your financial advisor before you make your investment choice.

The fund prospectus is the key document of the investment fund. It provides comprehensive details of the fundamental mechanics of the fund, along with an in-depth assessment of the risks it carries. While the fund prospectus is an important document it can also be a daunting one. The depth of information can often be overwhelming and jargon-heavy, and investors may be unsure how to interpret it without help from a financial advisor.

UCITS funds currently also produce a ‘simplified prospectus’ providing a summary of the main prospectus, but European lawmakers have decided to replace this by 2011 with a Key Information Document (KID). The KID will provide a concise yet comprehensive overview of the fund’s main features, on two A4 pages. Once the KID is introduced the ALFI Investor Centre web site will provide details of how to read and understand the information it contains.

What to look for in a fund prospectus

Information within a fund prospectus falls into four main categories: investment objectives and strategies; risk; performance; and information for investors. Before reading the fund prospectus, the very first thing to do is to look for the date of issue. A fund prospectus is reissued periodically, whenever this is required by significant changes to the investment fund, and investors should ensure they have the current version. A prospectus can normally be found on the fund management or fund promoter’s website along with any updates on fund details.

Investment objective and policy

All investment funds are launched with a clearly defined investment goal or policy. The prospectus will explain what investment policy and asset classes will be used to achieve these goals, and in many cases the benchmarks (usually indices) it will use to measure its success or otherwise. Details of the targeted index are also provided, especially for passive funds that simply aim to replicate the index as accurately as possible.

Two different investment funds may have the same investment goal but use different methods to achieve it. The prospectus will outline what investment restrictions and limits the fund is operating within – for instance, the maximum proportion of the fund that can be invested in a single asset, and whether and how the manager may use derivatives. Using this section of the prospectus, investors can decide whether the fund’s investment goals and policy are in line with their own investment needs.

Risk

It is essential to understand the type of risk an investment fund will incur in order to achieve its goals, and this should be set out clearly in the prospectus. However it is equally essential to understand that there are different types of risk. This section of the prospectus should examine the kinds of risk the fund is exposed to – such as credit, liquidity, interest rate, currency and market risk. Beside the risk profile of the fund you may also see details about the risk profile of a typical investor. The extent of risk to which a fund is exposed will help determine if the fund is a suitable investment choice for you.

The prospectus should explain, for example, that a highly focused equity fund is liable to face a significantly greater degree of risk than a more diversified fund. The prospectus of a bond fund may highlight the inherent quality and creditworthiness of securities from industrialised regions compared with those from emerging economies.

Performance

A prospectus may contain performance information that provides a historical review of the investment fund’s performance over specific time periods. It may allow you to see whether the fund has met its performance goals. Charts can show the evolution of the fund’s performance and provide a clear visual analysis of its price fluctuations (volatility). This will also help you to compare the performance of funds with similar goals from different fund management groups.

However, it’s important to remember that not all investment funds that appear similar are managed in the same way. Comparing fund documentation can help you identify differences in structure and strategy. Crucially, every fund prospectus will state clearly that past performance is not a predictor of future performance – something investors always need to keep in mind.

Investor information

This section of the prospectus will include information on how the investment fund is valued and details of how the net asset value (NAV) at which you buy or sell shares or units in the fund is calculated. It will tell you how you can invest and what steps you must take to redeem your shares or units in the fund, and the costs that will apply. The prospectus will also provide details of any minimum transaction or account levels that may apply.

The annual report

A investment fund’s annual financial report gives you the opportunity to see if the managers are doing their job properly. It is an important document that examines the fund’s operations for a specific period and the overall financial position. In the introduction by the fund manager you will find a review of the fund’s overall performance and a discussion about the markets and investments. The annual report should help you assess whether the fund is doing what it promised to do, and whether it remains relevant to your needs and investment profile. Generally an annual (or half-yearly) report will set out the fund’s return, the assets it holds and expenses incurred. The annual report will also contain a report from the fund’s independent auditor, who will have checked the accuracy of the fund’s accounts.

Marketing material will indicate the benefits of investing in a particular investment fund. It will use a style and tone of language that the reader can relate to and often draws on a particular lifestyle context such as retirement or school fees planning. Its aim is to attract new investors with the potential rewards of investing in such a fund. While the literature may be glossy and the images attractive, it should also contain important high-level information about the fund. It may include details of the fund’s specific investment goals and may also include past performance figures along with information about the fund’s investment style. Marketing material should always be read in conjunction with the fund prospectus.

How to buy or sell fund units or shares

The investment fund’s prospectus will tell you how often fund units or shares can be bought (subscription) and sold (redemption). Most UCITS funds offer daily subscription and redemption, although some restrict this to once a week or twice a month. Sometimes funds are closed for new subscription and therefore cannot be purchased by investors, although in some cases existing investors may continue to purchase units or shares.

The purchase (subscription) cost and sales (redemption) proceeds will be equal to the value of your share of the fund’s assets, less any fees and commission charges. This information will be included in the fund’s prospectus.

The way fund units and shares can be purchased and sold varies from country to country and may differ as a result of the distribution channels used by the management or investment company. This information will be available from your financial advisor or the fund management company. The fund prospectus should also include details about distribution channels, paying agents and any other agents that provide this information.