Whatever type of investment fund you take and no matter what its investment strategy looks like, the objective of the fund is always the same: to achieve the best possible performance, in other words, to make the value of its investment grow as much as possible for the benefit of its investors.
We have already seen that investment funds may invest in an almost unlimited variety of assets: stocks, bonds, cash, real estate, collectibles, precious metals, commodities ….
Once the choice of assets made, the fund will specialize.
Consider a fund that is invested in equities.
This fund may start by specializing geographically, by limiting its investments on specific continents, economic zones, regions or countries.
It can also specialize in one or more well-defined economic sectors such ass biotechnology, banking, health, automotive, telecommunications or computers …
Then, an additional criterion of specialization may be the size and / or the reputation of the companies in which it will invest: large-cap companies or, on the contrary, small and medium sized enterprises, global brands or rather young companies that have yet to gain a reputation …
The fund manager will probably also consider whether to invest more in shares of companies which he believes are undervalued and do not reflect the true value of the company (so-called “value stocks”) or in shares of companies that offer significant growth potential (so-called “growth stocks”). Or in shares of companies which regularly distribute above average dividends to their shareholders (“income stocks”)…
Obviously, the manager will not be limited to a single criterion of specialization, but will combine several of them and focus, for example, on very large US companies that pay high dividends. All sorts of combinations are conceivable.
Once the decision on the specialization is taken, it is essential to select the “right” stocks, i.e. to find those that are likely to deliver the best performance. To do this, the fund managers conduct a lot of research and analysis (or have them carried out by specialists) with the aim of identifying slightly faster than other investors that particular company that will make a super performance and investing in its shares before the rising demand from other investors pushes their price up.
There’s no foolproof road to top performance
But beware: THE surefire, infallible, foolproof system to make the right choice in equities does not exist! There is more than one way to find good investment opportunities.
It is said that managers who spend a lot of time and effort identifying the best assets to invest in are managing their fund actively. The funds managed that way are “active funds”.
If we want to measure the performance of the fund (and to assess whether the manager has done a good job), we compare it to the stock market index calculated regularly for the particular market in which the fund invests. This index measures the performance of the overall market.
The goal of any manager is to achieve a performance superior to that index, to “beat the market”.
But it turned out that this is an extremely difficult exercise and that only a minority of managers delivers a performance that is better than the overall market over a period of several years. Each company “lives”, develops over the years, has its ups and downs, and we are never safe from surprises, be they positive or negative. The scandal over fraudulent manipulation of polluting emissions of its cars by the German manufacturer Volkswagen that led to a dramatic drop in the company’s share price is a telling example.
The alternative of trying to beat the market
Given the difficulty of beating the market, some managers have abandoned this ambition and simply target a performance that is as close as possible to that of the corresponding market index. To do this, they do not need to carry out extensive research and analysis to select the best securities. They simply replicate the market index by investing in all securities contained in the Index, and this in exactly the same proportions that the individual securities have in the index.
In the German DAX index, for example, that reflects the market for German equities, car manufacturer BMW has a weight of 3.17 percent, software maker SAP a share of 8.15 percent and Deutsche Bank accounts for 2.85 percent *. An investment fund that wants to replicate the DAX index will just invest 3.17 of the money entrusted to it by investors in BMW shares, 8.15 percent in SAP shares, 2.85 percent in Deutsche Bank shares and so on. That way, its performance will certainly never be higher than that of the index, but it will not be much worse either.
It is said that these managers manage their funds passively, and these funds are called “passive funds”. Besides the active funds, they are another important category of funds. In our article entitled “Passive management: the path of least risk … for the manager,” we explain a bit more in detail how this type of fund works and what advantages and disadvantages it has.