In our article about diversification, we have seen that if we want to invest our money in shares, for example, we should not put all our eggs in one basket by investing all of our savings in shares of the same company. It would be wiser to spread our investment over several shares, preferably of companies from different sectors, regions, or even countries, thereby reducing the risk of incurring substantial losses when the price of one of our shares falls. However, we have also seen that the costs associated with transactions on the stock market make diversification relatively costly.
Watch our related podcast “What is an investment fund?”
To reduce costs, we can look for relatives, friends, neighbors or acquaintances who are willing to join us to invest together. If we put all the money we want to invest in a common pot and we use the content of this pot to invest collectively, we can invest higher amounts, obtain better conditions and reduce costs while being able, at the same time, to acquire a wider range of stocks.
If we are numerous enough and if our common pot contains enough money, we can go a step further and hire an experienced professional who will help us identify those stocks that offer the highest potential for gains. And if our investments generate profits, we can either keep them in the pot and invest them as well, or we can decide to distribute them among us proportionally to the amount that each of us has paid into the pot.
How does investment fund work?
An investment fund works in principle in the same way, with the significant difference that the initiative to create such a “common pot” does not emanate from a group of investors, but from a financial institution. This financial institution sets up an “investment fund” (also known as a mutual fund) and then starts searching for investors who might be interested in participating in the fund by paying money into it. An investment fund is therefore nothing other than an “undertaking for collective investment” (UCI). This term may sound somewhat cumbersome, but it expresses quite well what we are talking about.
Let’s see how this works in practice:
Imagine a financial institution that has a team of employees who monitor the Japanese equity market very closely and who know this market particularly well. Instead of restricting itself to exclusively using this expertise for buying Japanese stocks for its own account, the financial institution can decide to exploit this expert knowledge further by setting up an investment fund.
This investment fund commits to pursuing a specific investment strategy, in our case: to invest exclusively in Japanese equities. Any investor interested in investing in Japanese equities can put money into this fund. In return he will receive shares or units in the fund representing his payment. The money collected by the fund is managed by its team of experts who buy and sell Japanese shares on behalf of the fund and manage the portfolio of shares acquired. If the fund makes a profit, this is either reinvested into the fund or paid out to the participating investors in the form of dividends. Finally, the fund buys back its own shares or units from investors who wish to withdraw their savings and exit the fund.
Investment funds are regulated investment vehicles
There is a wide variety of investment funds on the market. In principle, an investment fund may invest not only in equities but also in other securities, real estate, precious metals, art, noble wines … or even in other investment funds.
Depending on the type of investors they are intended for and the investments they make, investment funds are more or less regulated and monitored by the authorities supervising the financial markets.
The most regulated and supervised investment funds are “undertakings for collective investment in transferable securities” (UCITS). As their name suggests, UCITS may exclusively invest in securities, i.e. in shares, bonds and money market instruments. As UCITS are primarily intended for retail investors, we dedicate a separate article to this type of investment fund.
Investment funds are not a recent invention. Their concept dates back to the 18th century. In 1774, a similar organization called “Eendracht Maakt Magt” was established in the Netherlands. The “West Cornwall Mining Investment Company” was born in Britain in 1836, the Swiss Société civile Genevoise d’emploi de fonds in 1849. The “Scottish American Investment Trust” dates back to 1873, the “Boston Personal Property Trust” to 1894 and the German “Zickert’scher Kapitalverein” to 1924. The first Luxembourg investment fund, “FCP Eurunion”, emerged only in 1959.