Overview of Investment Funds

When investors decide to invest in a particular asset class, such as equities, there are two
ways they can do it: direct investment or indirect investment.
Direct investment is when an individual personally buys shares in a company, such as buying
shares in Apple, the technology giant.
Indirect investment is when an individual buys a stake in an investment fund, such as a
mutual fund that invests in the shares of a range of different types of companies, perhaps
including Apple.

Achieving an adequate spread of investments through holding direct investments can require
a significant amount of money and, as a result, many investors find indirect investment very
attractive. There is a range of funds available that pool the resources of many investors to
provide access to a range of investments. These pooled funds are known as collective
investment schemes (CISs), funds, or collective investment vehicles. The term ‘collective
investment scheme’ is an internationally recognised
one, but investment funds are also very well-known by other names, such as mutual funds,
unit trusts or open-ended investment companies (OEICs).

Other terminology that you will encounter is open-ended funds and closed-ended funds. An
openended fund is one that can create new shares in response to investor demand or cancel
them when sold so that their capital can expand or contract – an example is a mutual fund. A
closed-ended fund, by contrast, has a fixed capital base so if an investor wants to buy shares,
they will do so on the stock exchange and buy them from another investor who wants to sell.
They have a fixed capital base as is seen with US closed-ended funds.
An investor is likely to come across a range of different types of investment funds, as many
are now established in one country and then marketed internationally. Funds that are
established in Europe and marketed internationally are often labelled as undertakings for
collective investment in transferable securities (UCITS) funds, meaning that they comply
with the rules of the EU UCITS directive. The UCITS branding is seen as a measure of
quality that makes them acceptable for sale in many countries in the Middle East and Asia.

The main European centre for establishing funds that are to be marketed internationally is
Luxembourg, where investment funds are often structured as an OEIC known as a Société
d’Investissement à Capital Variable (SICAV). Other popular centres for the establishment of
investment funds that are marketed globally include the UK, Ireland and Jersey, where the
legal structure is likely to be either an OEIC or a unit trust.

The international nature of the investment funds business can be seen by looking at the funds
authorised for sale in Bahrain, which has one of the widest range of funds available in the
Gulf region with over 1,700 funds registered for sale. Some of these are domiciled in
Bahrain, but many are funds from international fund management houses such as BlackRock,
Fidelity and JPMorgan. They include SICAVs (see section 2.2.1), investment companies
with variable capital (ICVCs) – (see section 2.2.3) and unit trusts from a range of
internationally recognised firms.

The Benefits of Collective Investment

Investment funds pool the resources of many investors, with the aim of pursuing a common
investment objective.
This pooling of funds brings several benefits, including:
• economies of scale
• diversification
• access to professional investment management
• access to geographical markets, asset classes or investment strategies which might
otherwise be inaccessible to the individual investor
• in some cases, the benefit of regulatory oversight, and
• in some cases, tax deferral.

The value of shares and most other investments can fall as well as rise. Some might fall
spectacularly, such as when Enron collapsed or when banks had to be bailed out during the
financial crisis. However, when an investor holds a diversified pool of investments in a
portfolio, the risk of single constituent investments falling spectacularly could be offset by
outperformance on the part of other investments. In other words, risk is lessened when the
investor holds a diversified portfolio of investments (of course, the opportunity of a startling
outperformance is also diversified away – however, many investors are happy with this if it
reduces their risk of total or significant loss).

An investor needs a substantial amount of money before they can create a diversified
portfolio of investments directly. If an investor has only US$3,000 to invest, and wants to buy
the shares of 30 different companies, each investment would be US$100. This would result in
a large amount of the US$3,000 being spent on commission, since there will be minimum
commission rates of, say, US$10 on each purchase.

Alternatively, an investment of US$3,000 might go into an investment fund with, say, 80

different investments, but, because the investment is being pooled with that of lots of other
investors, the commission as a proportion of the fund is very small.

An investment fund might also be invested in shares from many different sectors; this
achieves diversification from an industry perspective (thereby reducing the risk of investing
in a number of shares whose performance is closely correlated). Alternatively, it may invest
in a variety of bonds. Some investment funds put limited amounts of investment into bank
deposits and even into other investment funds.

The other main rationale for investing collectively is to access the investing skills of the fund
manager. Fund managers follow their chosen markets closely and will carefully consider
what to buy and whether to keep or sell their chosen investments. Few investors have the
skill, time or inclination to do this as effectively themselves.

However, fund managers do not manage portfolios for nothing. They might charge investors’
fees to become involved in their CIS (entry fees or initial charges) or to leave (exit charges),
plus annual management fees. These fees are needed to cover the fund managers’ salaries,
technology, research, their dealing, settlement and risk management systems, and to provide a
profit. Equally, there is no guarantee that professional management will deliver superior
results and that investment funds will suffer during market downturns. Indeed, recent
research has highlighted that many actively managed funds consistently fail to beat their
benchmarks, which has given rise to a growing debate between proponents of active versus
passive investing (see below) and placed pressure on actively managed funds to reduce their
charges.
Investment Strategies

There is a wide range of funds with many different investment objectives and investment
styles. Each of these funds has an investment portfolio managed by a fund manager according
to a clearly stated set of objectives.
An example of an objective might be to invest in the shares of UK companies with above-
average potential for capital growth and to outperform the FTSE (Financial Times Stock
Exchange) All-Share index. Other funds’ objectives could be to maximise income or to
achieve steady growth in capital and income.
In each case, it will also be clear what the fund manager will invest in; for example, shares
and/or bonds and/or property and/or cash or money instruments; and whether derivatives will
be used to hedge currency or other market risks.
It is also important to understand the investment style the fund manager adopts. Investment
styles refer to the fund manager’s approach to choosing investments and meeting the fund’s
objectives. In this section, we will look at the difference between active and passive
management.

Passive Management

Passive management is seen in those types of investment funds that are often described as
index-tracker funds. Index-tracking, or indexation, involves constructing a portfolio in such a
way that it will track, or mimic, the performance of a recognised index. Index funds have
been one of the fastest growing areas of investment.

Indexation is undertaken on the assumption that securities markets are efficiently priced and
cannot therefore be consistently outperformed. Consequently, no attempt is made to forecast
future events or outperform the broader market.

The advantages of employing indexation are that:

• Relatively few active portfolio managers consistently outperform benchmark indices.
• Once set up, passive portfolios are generally less expensive to run than active portfolios,
given a lower ratio of staff to funds managed and lower portfolio turnover.

The disadvantages of adopting indexation, however, include the following:

• Performance is affected by the need to manage cash flows, rebalance the portfolio to
replicate changes in index constituent weightings and adjust the portfolio for stocks coming
into, and falling out of, the index. This can lead to tracking error if the performance does not
match that of the underlying index.
• Most indices assume that dividends from constituent equities are reinvested on the ex-
dividend (xd) date, whereas a passive fund can only invest dividends when they are received,
up to six weeks after the share has been declared ex-dividend.
• Indexed portfolios may not meet all of an investor’s objectives.
• Indexed portfolios follow the index down in bear markets.

Active Management

In contrast to passive management, active management seeks to outperform a predetermined

benchmark over a specified period. It does so by employing fundamental and technical
analysis to assist in the forecasting of future events, which may be economic or specific to a
company, so as to determine the portfolio’s holdings and the timing of purchases and sales of
securities. Actively managed funds usually have higher charges than those that are passively
managed.

Two commonly used terms in this context are ‘top-down’ and ‘bottom-up’. Top-down means
that the manager focuses on economic and industry trends rather than the prospects of
particular companies. Bottom-up means that the analysis of a company’s net assets, future
profitability and cash flow and other company-specific indicators is a priority.

Fund Classification

Fund classification generally involves grouping funds with similar objectives. Not only does
this allow investors to match their objectives with funds that meet those objectives, but it also
allows investors to compare funds that have similar objectives. Most funds are broadly
categorised between those designed to provide ‘income’ and those designed to provide
‘growth’. Those funds that do not fall easily under these headings are in other categories
entitled capital protection, specialist funds, volatility managed, absolute/target return or
unclassified.

Open-Ended Funds

An open-ended fund is an investment fund that can issue and redeem shares at any time. Each
investor has a pro rata share of the underlying portfolio and so will share in any growth of the
fund. The value of each share is in proportion to the total value of the underlying investment
portfolio.

If investors wish to invest in an open-ended fund, they approach the fund directly and provide
the
money they wish to invest. The fund can create new shares in response to this demand,
issuing new shares or units to the investor at a price based on the value of the underlying
portfolio. If investors decide to sell, they again approach the fund, which will redeem the
shares and pay the investor the value of their shares, again based on the value of the
underlying portfolio.

An open-ended fund can, therefore, expand and contract in size based on investor demand,
which is why it is referred to as open-ended.

US Open-Ended Funds

The most well-known type of US investment fund is a mutual fund, as defined by the
Investment
Company Act of 1940 (the ‘40 Act’). Legally, it is known as an ‘open-end company’ under
federal
securities laws. A mutual fund is one of three main types of investment fund in the US; the
others are considered later in this chapter in the section on closed-ended funds.

Some of their key distinguishing characteristics include:

• The mutual fund can create and sell new shares to accommodate new investors.
• Investors buy mutual fund shares directly from the fund itself, rather than from other
investors on a secondary market such as the New York Stock Exchange (NYSE) or National
Association of Securities Dealers Automated Quotations (NASDAQ).
• The price that investors pay for mutual fund shares is based on the fund’s net asset value
(the NAV, which is the value of the underlying investment portfolio) plus any charges made
by the fund.
• The investment portfolios of mutual funds are typically managed by separate entities known
as investment advisers, who are registered with the Securities Exchange Commission (SEC),
the
US regulator.

Investors can place instructions to buy or sell shares in mutual funds by contacting the fund
directly. However, in practice, most mutual fund shares are sold mainly through brokers,
banks, financial planners or insurance agents.

The price that an investor will pay to buy shares or receive when they are redeemed is based
on the NAV of the underlying portfolio. A mutual fund will value its portfolio daily in order
to determine the value of its investment portfolio, and from this calculate the price at which
investors will deal. The NAV is available from the fund, on its website and in the financial
pages of major newspapers.

When an investor buys shares, they pay the current NAV per share plus any fee the fund
imposes. When an investor sells their shares, the fund will pay them the NAV minus any
charges made for redemption of the shares. All mutual funds will redeem or buy back an
investor’s shares on any business day and must send payment within seven days.

Operating a mutual fund involves costs such as shareholder transaction charges, investment
advisory fees, and marketing and distribution expenses. Mutual funds pass along these costs
to investors by imposing charges. SEC rules require mutual funds to disclose both
shareholder fees and operating expenses in a fee table near the front of a fund’s prospectus.

The tax treatment of a US fund varies depending upon its type. For example, some funds are
classed as tax-exempt funds, such as a municipal bond fund where all of the dividends are
exempt from federal and sometimes state income tax, although tax is due on any capital
gains.
For other mutual funds, income tax is payable on any dividends and gains made when the
shares are sold. In addition, investors may also have to pay taxes each year on the fund’s
capital gains.

This is because US law requires mutual funds to distribute capital gains to shareholders if
they sell securities for a profit that cannot be offset by a loss.
The tax treatment of mutual funds for non-US residents means that, in practice, funds
domiciled in Europe or elsewhere are more likely to be suitable.

European Open-Ended Funds

In Europe, three main types of funds are encountered – SICAVs, unit trusts and OEICs.

As mentioned in section 1 of this chapter, many of these are structured as UCITS funds.
UCITS refers to a series of EU regulations that were originally designed to facilitate the
promotion of funds to retail investors across Europe. A UCITS fund, therefore, complies with
the requirements of these directives, regardless of which EU country it is established in.

The directives have been issued with the intention of creating a framework for cross-border
sales of investment funds. They allow an investment fund to be sold throughout the EU,
subject to regulation by its home country regulator.

The key point to note, therefore, is that when an investment fund first seeks authorisation
from its
regulator, it will seek authorisation as a UCITS fund. For example, instead of an investment
fund being authorised by the Luxembourg regulator solely for marketing to the general public
in Luxembourg, approval as a UCITS fund means that it can be marketed across the EU.

While UCITS regulations are not directly applicable outside of the EU, other jurisdictions,
such as
Switzerland and Hong Kong, recognise UCITS when funds are applying for registration to
sell into those countries. In many countries, UCITS is seen as a brand that signifies the
quality of how a fund is managed, administered and supervised by regulators.

Open-Ended Investment Companies (OEICs)

An OEIC is another form of investment fund found in Europe. They are a form of ICVC that
is structured as a company with the investors holding shares.

The term ‘OEIC’ is used mostly in the UK, while in Ireland they are known as a variable
capital company (VCC). They have similar structures to SICAVs and, as with SICAVs and
unit trusts, investors deal directly with the fund when they wish to buy and sell.

The key characteristics of OEICs are the parties that are involved and how they are priced.

When an OEIC is set up, it is a requirement that an authorised corporate director (ACD)
and a depository are appointed. The ACD is responsible for the day-to-day management of
the fund, including managing the investments, valuing and pricing the fund and dealing with
investors. It
may undertake these activities itself or delegate them to specialist third parties.
• The fund’s investments are held by an independent depositary, responsible for looking after
the
investments on behalf of the fund’s shareholders and overseeing the activities of the ACD.
The
depository plays a similar role to that of the trustee of a unit trust. The depository is the legal
owner of the fund investments and the OEIC itself is the beneficial owner, not the
shareholders.

Closed-Ended Investment Companies

A closed-ended investment company is another form of investment fund. When they are first
established, a set number of shares is issued to the investing public, and these are then
subsequently traded on a stock market. Investors wanting to subsequently buy shares do so on
the stock market from investors who are willing to sell.
The capital of the fund is, therefore, fixed and does not expand or contract in the way that an
open-ended fund’s capital does. For this reason, they are referred to as closed-ended funds in
order to differentiate them from mutual funds, SICAVs, unit trusts and OEICs.

Characteristics of Closed-Ended Investment Companies

US

In the US, they are referred to as closed-end funds and are one of the three basic types of
investment companies alongside mutual funds (see section 2.1) and unit investment trusts.
In the US, closed-end funds come in many varieties and can have different investment
objectives, strategies and investment portfolios. They also can be subject to different risks,
volatility and charges.

They are permitted to invest in a greater amount of illiquid securities than are mutual funds.
(An illiquid security generally is considered to be a security that cannot be sold within seven
days at the approximate price used by the fund in determining NAV.) Due to this feature,
funds that seek to invest in markets where the securities tend to be more illiquid are typically
organised as closed-end funds.

The other main type of US Investment Company is a unit investment trust (UIT). A UIT does
not actively trade its investment portfolio, instead it buys a relatively fixed portfolio of
securities – for example, five, ten or 20 specific stocks or bonds – and holds them with little
or no change for the life of the fund. Like a closed-end fund, it will usually make an initial
public offering of its shares (or units), but the sponsors of the fund will maintain a secondary
market, which allows owners of UIT units to sell them back to the sponsors and allows other
investors to buy UIT units from the sponsors.

Europe

In Europe, closed-ended funds are usually known as investment trusts and more recently as
investment companies.
Investment trusts were one of the first investment funds to be set up. The first funds were
set up in the UK in the 1860s and, in fact, the very first investment trust to be established is
still operating today.

Its name is Foreign & Colonial Investment Trust, and it is a global growth trust that invests in
over 30 markets and has around £2 billion of funds under management.
Despite its name, an investment trust is actually a company, not a trust. As a company it has
directors and shareholders. However, like a unit trust, an investment trust will invest in a
range of investments, allowing its shareholders to diversify and lessen their risk.

Some investment trust companies have more than one type of share. For example, an
investment trust might issue both ordinary shares and preference shares. Such investment
trusts are commonly referred to as split capital investment trusts.
In contrast with OEICs and unit trusts, investment trust companies are allowed to borrow
money on a long-term basis by taking out bank loans and/or issuing bonds. This can enable
them to invest the borrowed money in more stocks and shares – a process known as gearing
or leverage. Also, some investment trusts have a fixed date for their winding-up.
Real Estate Investment Trusts (REITs)

Real estate investment trusts (REITs) are well established in countries such as the US, UK,
Australia, Canada and France. Globally, the market is worth more than US$400 billion.

They are normal investment companies that pool investors’ funds to invest in commercial and
possibly residential property.

One of the main features of REITs is that they provide access to property returns without the
previous disadvantage of double taxation. Until recently, when an investor held property
company shares, not only would the company pay corporation tax, but the investor would be
liable to tax on dividends and any growth. Under the rules for REITs, no corporation tax is
payable, providing that certain conditions are met and distributions are instead taxable on the
investor.

REITs give investors access to professional property investment and might provide them with
new opportunities, such as the ability to invest in commercial property. This allows them to
diversify the risk of holding direct property investments.

This type of investment trust also removes a further risk from holding direct property, namely
liquidity risk or the risk that the investment will not be able to be readily realised. REITs are
closed-ended funds and are quoted on stock exchanges and shares in REITs are bought and
sold in the same way as other investment trusts.

Exchange-Traded Funds (ETFs)

An exchange-traded fund (ETF) is an investment fund, usually designed to track a particular

index. This is typically a stock market index, such as the S&P (Standard & Poor’s) 500. The
investor buys shares in the ETF which are quoted on the stock exchange, like investment
trusts. More recently, ETFs have been issued that track specially constructed indices
representing, for example, the performance of actively managed funds. However, unlike
investment trusts, ETFs are open-ended funds. This means that, like OEICs, the fund gets
bigger as more people invest and gets smaller as people withdraw their money.

ETFs use passive investment management which is a method of managing an investment

portfolio that seeks to match the performance of a broad-based market index. Its investment
style is described as passive because portfolio managers do not make decisions about which
securities to buy and sell; instead, they invest in the same securities that make up an index. It,
therefore, seeks to hold a portfolio that mirrors the index it is tracking and undertakes trading
only to ensure that the portfolio’s performance is in line with the index.

Most index tracker funds are based on market capitalisation-weighted indices, such as the
FTSE 100 or S&P 500, where the largest stocks in the index by market value have the biggest
influence on the index’s value. The fund will seek to track the index using either physical or
synthetic replication.

Physical replication is the traditional form of index replication and is the one favoured by the
largest and long-established ETF providers. It employs one of three established tracking
methods:
1. Full replication – this method requires each constituent of the index being tracked to be
held in accordance with its index weighting. Although full replication is accurate, it is also
the most expensive of the three methods and so is only really suitable for large portfolios.
2. Stratified sampling – this method requires a representative sample of securities from each
sector of the index to be held. Although this method is less expensive, the lack of statistical
analysis renders it subjective and potentially encourages biases towards those stocks with the
best perceived prospects.
3. Optimisation – this method costs less than fully replicating the index tracked, but is
statistically more complex. Optimisation uses a sophisticated computer modelling technique
to find a representative sample of those securities which mimic the broad characteristics of
the index tracked.

Synthetic replication involves the fund manager entering into a swap (an OTC derivative)
with a market counterparty to exchange the returns on the index for a payment. The
advantage of this approach is that responsibility for tracking the index performance is passed
on to the swap provider and costs are lower. The downside is that the investor is exposed to
counterparty risk, namely that the swap provider fails to meet their obligations.

ETF shares may trade at a premium or discount to the underlying investments, but the
difference is usually minimal and the ETF share price essentially reflects the value of the
investments in the fund. The investor’s return is in the form of dividends paid by the ETF,
and the possibility of a capital gain (or loss) on sale.

Shares in ETFs are bought and sold through a stockbroker on a stock exchange and exhibit
the following charges:
• There is a spread between the price at which investors buy the shares and the price at which
they can sell them. This is usually very small, for example just 0.1% or 0.2% for, say, an ETF
tracking the FTSE 100.
• An annual management charge is deducted from the fund. Typically, this is 0.5% or less.
• The investors pay stockbroker’s commission when they buy and sell.

Alternative Investment Funds (AIFs)

Hedge Funds

Hedge funds are reputed to be high risk. However, in many cases, this perception stands at
odds with reality. In their original incarnation, hedge funds sought to eliminate or reduce
market risk. That said, there are now many different styles of hedge fund – some risk-averse,
and some employing highly risky strategies. It is, therefore, not wise to generalise about
them.

The most obvious market risk is the risk that is faced by an investor in shares – as the broad
market moves down, the investor’s shares also fall in value. Traditional ‘absolute return’
hedge funds attempt to profit regardless of the general movements of the market by carefully
selecting a combination of asset classes, including derivatives, and by holding both long and
short positions (a short position may involve the selling of shares which the fund does not at
that time own in the hope of buying them back more cheaply if the market falls).

However, innovation has resulted in a wide range of complex hedge fund strategies, some of
which place a greater emphasis on producing highly geared returns than on controlling
market risk.
Many hedge funds have high initial investment levels, meaning that access is effectively
restricted to wealthy investors and institutions.

The common aspects of hedge funds are the following:

• Structure – most hedge funds are established as unauthorised and therefore unregulated
CISs, meaning that they cannot be generally marketed to private individuals because they are
considered too risky for the less financially sophisticated investor.
• High investment entry levels – most hedge funds require minimum investments in excess
of US$500,000 some exceed US$1 million.
• Investment flexibility – because of the lack of regulation, hedge funds are able to invest in
whatever assets they wish (subject to compliance with the restrictions in their constitutional
documents and prospectus). In addition to being able to take long and short positions in
securities like shares and bonds, some take positions in commodities and currencies. Their
investment style is generally aimed at producing absolute returns – positive returns regardless
of the general direction of market movements.
• Gearing – many hedge funds can borrow funds and use derivatives to potentially enhance
returns.
• Liquidity – to maximise the hedge fund manager’s investment freedom, hedge funds
usually impose an initial ‘lock-in’ period of between one and three months before investors
can sell their investments on. This increases the notional exposure to market volatility and
adds many multiples to the cash (nominal) value of the investment (also known as leverage).
• Cost – hedge funds typically levy performance-related fees which the investor pays if
certain performance levels are achieved, otherwise paying a fee comparable to that charged
by other growth funds. Performance fees can be substantial, with 20% or more of the net new
highs (also called the ‘high water mark’) being common.

Private Equity

Private equity is medium- to long-term finance, provided in return for an equity stake in
potentially high-growth companies. It can take many forms, from providing venture capital to
complete buy-outs.

For a firm, attracting private equity investment is very different from raising a loan from a
lender. Private equity is invested in exchange for a stake in a company and, as shareholders,
the investors’ returns are dependent on the growth and profitability of the business. They,
therefore, face the risk of failure, just like the other shareholders.

The private equity firm is rewarded by the company’s success, generally achieving its
principal return through realising a capital gain on exit. This may involve:

• the private equity firm selling its shares back to the management of the investee company
• the private equity firm selling the shares to another investor, such as another private equity
firm
• a trade sale, that is, the sale of company shares to another firm, or
• the company achieving a stock market listing.
Private equity firms raise their capital from a variety of sources, but mainly from large
investing institutions. These may be happy to entrust their money to the private equity firm
because of its expertise in finding businesses with good potential.

Few people or institutions can afford the risk of investing directly in individual buy-outs and,
instead, use pooled vehicles to achieve a diversification of risk. Traditionally, this was
through investment trusts, such as 3i or Electra Private Equity.

With the increasing amount of funds being raised for this asset class, methods of raising
investment have moved on. Private equity arrangements are now usually structured in
different ways from retail investment funds. They are usually set up as limited partnerships
with high minimum investment levels or as private placement funds. Like hedge funds, there
are generally restrictions on when an investor can realise their investment.