WHAT ARE INVESTMENT FUNDS?
I'm Jose. I'm a finance professional with experience in trading and investing in financial markets. I also have a background in economic journalism and journalistic writing.
If you've heard about investment funds and are wondering what these products are, how they work, and how you can invest in them, you'll find the answers in this article.
Investment funds are used by all types of investors, precisely because of their ease of use and because they provide a basket of assets. Although there are different types of funds, each following a specific strategy, they are generally considered a long-term investment mechanism. Below, we explain everything you need to know.
What is an investment fund?
An investment fund, as its name suggests, is a pool of money belonging to multiple investors. This pooled money is managed by a professional manager (or a management team), who invests it in a basket of assets (stocks, bonds, deposits, futures, etc.) in order to generate returns for those investors.
The fund manager follows a specific investment strategy known to the investors (the investors are called "participants" since they have shares in the fund).
In summary, an investment fund is a financial product that pools the money of a group of participants to be invested in a diversified portfolio of assets, following a specific and transparent strategy.
How the funds work and their advantages
For an investment fund to function, several figures and elements:
- The management company: This is the entity, accredited and supervised by the relevant regulatory body, responsible for the administration and representation of the fund. The management team works for it.
- The custodian entity is responsible for the safekeeping of the fund's money and assets. This includes oversight. Naturally, it must be an authorized and properly regulated entity, typically a bank.
- Fund assets: This is the money or assets in which the fund is invested. It is divided into units, each representing ownership of a portion of the fund. Naturally, the fund's value changes daily, depending on the performance of the markets in which it is invested (plus any inflows and outflows from investors).
- Participants: As mentioned, this refers to each of the investors who hold shares in the fund. In other words, they contribute money to the fund and receive shares in return.
The purchase and sale of shares in a fund are called “subscription” and “redemption” respectively.
Any investor can subscribe to shares in a fund that interests them. But at what price?
At this point, another important concept for funds comes into play: "the net asset value of the shares." Although it sounds very technical, it simply refers to their price.
The net asset value is obtained by dividing the fund's assets, whose valuation is determined by the prices of assets in the market on a specific day, by the number of shares in circulation.
When you want to subscribe for or redeem shares, the net asset value of those shares on a specific day will be applied (usually one or two days after the request, as you will soon discover).
The return you get on an investment fund is the difference in price (net asset value) of the shares between the time of subscription and redemption (the purchase and the sale).
Advantages of investment funds
Investment funds were invented precisely to make financial investments more accessible to small savers. Their advantages are as follows:
- Diversification: This is one of the main advantages of investment funds; it allows for the creation of a diversified portfolio of assets. This is difficult for individual investors, primarily due to capital and time constraints. Diversification is one of the best ways to mitigate risk, as the poor performance of one asset is offset by the strong performance of others. For this reason, funds are one of the most popular products for long-term investing.
- Ease of access: As we'll see shortly, investing in investment funds is very simple. Furthermore, they provide access to international assets, exotic markets, and other types of investments that can be complex (for example, Asian stock exchanges).
- Liquidity: While some funds limit the subscription and redemption of shares, these are usually in the minority and typically have a special nature (for example, real estate funds). Generally, you can buy and sell shares at any time. The fund's management company has the power to issue new shares and withdraw existing ones. In short, you shouldn't have any trouble entering and exiting a fund at will.
- Professional management: the managers are professional entities and have trained personnel for portfolio management (managers who meet with the companies in which they invest, analysts, etc.).
- Security: All entities involved in an investment fund are regulated and must comply with financial regulations. The fund itself is registered. Furthermore, in Spain (and in Europe in general), in the event of bankruptcy or suspension of payments, the investor is protected by the Investment Guarantee Fund.
- Tax advantages: If you invest in investment funds in Spain, you can transfer capital between them without having to pay taxes on the sale of shares.
- Transparency in information: Before making a decision, the management company or the agent acting as the fund's distributor must provide you with an information brochure containing all relevant product details (investment policy, fees, risk level, etc.) so that you can make an informed decision. In addition, the management company issues periodic reports on the fund's performance, its portfolio, and other information of interest to investors.
How to invest in investment funds?
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MEXEM assistance in Spanish:
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📧 asistencia@mexem.com
Investment funds are not listed on a financial market, although there is a subtype of funds that are: ETFs (which stands for Exchange Traded Funds).
This means that you cannot buy and sell shares on a stock exchangethrough a broker.
In any case, the process with funds is very simple. The investment is made by subscribing to shares, and for this you only need to submit an application.
How to subscribe to shares?
Although the fund manager can market its funds directly, it's more common to invest in a fund through an agent who acts as its distributor, such as a bank, an online platform, or even brokers that offer this service. There are several ways to invest.
As we mentioned, the fund managers issue the number of shares necessary to meet subscription requests. Therefore, there is no problem investing at any time.
When you buy (subscribe to) shares, the money becomes part of the fund's assets and you will own a portion of the investment portfolio, in proportion to the shares you acquire.
It is important that, before deciding to buy shares, you read the prospectus, the latest report, and all the documents made available to you, so that you understand the product in which you will be investing your money. The information you should pay attention to includes:
- Risk profile.
- Investment policy.
- Portfolio distribution.
- Main assets in which it is invested.
- Commissions.
- Historical returns.
- Recommended time period to maintain the investment.
- Inter alia.
If you have any questions, you can ask the fund distributor.
The price of the shares (the net asset value) can be the price on the same day you submit your subscription request (at the end of the trading day, and published the following day) or the price on the next day (published two days later). This information is detailed in the fund's prospectus. You can also ask for it.
It's worth noting that some funds charge a fee for subscribing to shares, although this is not very common. This fee is calculated as a percentage of the amount you wish to invest.
You will probably need to open an account with the entity that provides you with the fund, in order to channel the movements related to subscriptions, redemptions, income from periodic rents, etc. (there are "distribution funds", that is, those that distribute the interest, dividends or income of the portfolio's assets among the participants).
Finally, keep in mind that some funds may require a minimum initial investment.
How to get a refund for shares?
Redeeming fund shares is as simple as subscribing. It's a process of selling your shares to unwind your investment, and you can find all the terms and conditions clearly and transparently in the product's information documents.
Simply put, you need to contact the management company or entity where you contracted the fund (the marketing agent) and express your intention to redeem shares for a certain amount, whether it's your entire investment or a part of it.
Some fund managers require advance notice of redemption if the amount exceeds €300,000. Additionally, some funds also require a minimum investment amount to maintain investor status.
As we have said on several occasions, it is important that you read all the documentation before purchasing a product to be aware of these issues.
Regarding the net asset value at which your shares are sold, it's calculated in the same way as for redemptions, but you need to pay attention because there's a "cut-off time." If you submit your request after that time, it will be considered to have been made the following day.
You will normally receive the money in your account in about 3 days, starting from when the net asset value of the shares is calculated.
You should also be aware that redemption fees may apply (although they are not common). These are calculated as a percentage of the amount you intend to withdraw.
If you redeem shares at a price (net asset value) higher than the price at which you subscribed for them, you will get a return on your money.
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Main types of investment funds
There are a large number of investment funds on the market, offering investment strategies to suit all tastes and risk profiles. To distinguish them, they are grouped into categories based on the type of assets in which they invest, which also determines the level of risk they assume.
But, to summarize, these are some of the types of investment funds you will find most often.
Fixed income funds
These types of funds build their portfolios primarily using fixed-income assets (bonds, Treasury bills, commercial paper, debentures, etc.). This doesn't mean that 100% of their portfolio consists of these types of assets, but rather that the majority (at least 70%–75%) is.
Fixed income refers to securities that offer an invariable return known in advance to the investor.
By providing a fixed and regular return, this asset class tends to be more stable (because it is also traded on a market and its price fluctuates). Therefore, fixed-income funds generally carry less risk than other securities. Their performance depends largely on interest rate variations.
You can find public fixed income funds (debt issued by governments and administrations), corporate fixed income funds (debt issued by companies), with different maturity dates, from different countries, etc.
Equity funds
Equity funds are characterized by the fact that their portfolio must consist mostly of company shares (at least 75%).
Equity refers to assets that provide income that is unknown in advance and likely to vary (such as company dividends).
As you can imagine, there is a vast universe of stocks and, therefore, a wide range of equity funds, depending on the sector, the country, the size (capitalization) of the companies in which it invests, etc.
For example, you can find a US stock fund that only invests in the technology sector.
Under normal conditions, stocks are riskier assets than bonds and other fixed-income securities, but they also have greater potential for returns.
Mixed funds
These types of funds can invest in fixed income and equities interchangeably and in any proportion. The prospectus will specify the exact percentage that the manager can allocate to each asset class.
Furthermore, knowing the weight given to fixed income and variable income, you can get an idea of the risk and the ability to obtain returns.
Index funds
Index funds are not a category in themselves, but a class of funds that follow a very particular strategy: to reproduce the behavior of a market index.
There are indexed funds of fixed income (since there are indices that show the evolution of fixed income markets) and also of equity (which follow the evolution of some stock market index).
The philosophy behind these funds is to build a portfolio that mirrors the index they use as a benchmark. In other words, they invest in the same assets and in the same proportions. The manager simply adjusts the portfolio periodically based on any changes that may have occurred in the index. For this reason, this approach to portfolio management is called "passive management."
As you can imagine, they don't require analysts or extensive management work. Therefore, index funds have much lower management fees than actively managed funds.
Due to their market-following strategy and low fees, index funds have become one of the most popular long-term investment vehicles available. They are also used by robo-advisors to build their portfolios.
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