Investment funds are regulated investment vehicles (some are more regulated than others) that have to be approved by and are continuously supervised by the competent financial markets supervisory authority.
The most regulated investment funds are “undertakings for collective investment in transferable securities” (UCITS), while less regulated funds include the so-called alternative investment funds (such as hedge funds or Private Equity funds). But these are in principle not intended to be offered to retail investors.
The law requires that the assets of an investment fund be separated from those of the fund initiator. The safekeeping of the investment fund’s assets must be entrusted to a depositary (which must be a credit institution). The latter takes care of the day to day management of the Fund’s assets and must ensure that all transactions that affect the shares or units of the Fund (such as the issue, sale, redemption and cancellation of shares or units, or the calculation of its net asset value) take place according to the law and the management regulations.
These provisions aim to ensure that the fund’s assets are not affected in case of financial problems or bankruptcy of the fund company.
However, like any other investment, an investment in an investment fund involves risks.
Risk diversification does not mean elimination of risks
We have already seen in our article about diversification that a prudent investor does not put “all his eggs into one basket” and that an investment fund allows an investor to adequately diversify his investments to spread the associated risks.
But be careful: “Risk Diversification” does not mean “elimination of investment risks”. Never forget that by entrusting your savings to an investment fund, you do not invest in an abstract structure, but in a vehicle that in turn invests your savings in accordance with its investment policy. In other words, when buying an investment fund, you are investing ultimately in the assets in which the fund invests. By buying an investment fund that invests in German equities, you are simply buying German equities through the investment fund.
Whatever the investment fund of your choice, you will face market risk. If the prices on the market your fund has invested in are falling, even the best fund manager can hardly escape this trend, all the more so because the manager is obliged to stick to the investment policy the fund has committed to follow. Thus, a fund whose investment policy is to invest in German equities – and that investors bought for the very reason that they wanted to invest in German equities – cannot decide overnight to sell its German shares simply because the market is falling and start investing in French securities instead.
The degree of investment diversification – and reduction of associated risks – offered by an investment fund will also depend on the fund’s investment policy. Thus, a mutual fund that invests in a limited number of companies in a specific sector, such as biotechnology for example, offers a significantly lower degree of diversification than a fund that allocates its investments to a very high number of securities of companies from many different economic sectors.
The more diverse the fund’s equity portfolio, the greater the chance that a declining price of one security is compensated by a rising price of another one. (On the other hand, the probability that the rising price of a security is offset by the declining price of another one is real too. The more diverse a portfolio, the more limited is the chance for spectacular gains.)
UCITS funds are required by law to ensure adequate diversification of their investments.