Understanding Investment Funds: What Are They?

Investment funds are a type of financial product that pools capital from multiple investors to purchase a portfolio of various securities, such as stocks and bonds. This is usually done with the goal of earning higher returns than those offered by traditional investments. Investment funds are managed by professional portfolio managers who make investment decisions on behalf of the investors. They are also referred to as investment pools, collective investment vehicles, collective investment schemes, managed funds, or simply funds.

Investment fund types

Investment funds are created to pool investors' capital to invest in a portfolio of financial instruments, such as stocks, bonds, and other securities. There are several types of investment funds, including:

• Mutual Funds: These are the most common type of investment fund. Mutual funds pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are known for the types of securities they invest in, their investment objectives, and the returns they seek. Examples include stock funds, money market funds, bond funds, and target-date funds.
• Exchange-Traded Funds (ETFs): ETFs are similar to mutual funds but trade on exchanges like stocks, offering more flexibility and intraday trading. They often have lower expense ratios than mutual funds.
• Hedge Funds: Hedge funds are actively managed funds available to accredited investors. They face less regulatory burden and can invest in a wider range of asset classes using diverse strategies.
• Money Market Funds: These funds invest in short-term debt instruments, such as securities issued by banks, businesses, or governments, and provide a relatively safe and stable investment option.
• Regional Mutual Funds: Regional mutual funds focus on specific geographic regions, such as a country, continent, or group of countries, and invest in the securities of companies headquartered or generating significant revenue within that region.
• Sector and Theme Mutual Funds: Sector funds aim to profit from specific sectors like technology or healthcare, while theme funds cut across sectors, such as a fund focused on AI investing in multiple industries.
• Socially Responsible Mutual Funds: These funds, also known as ethical funds, invest only in companies and sectors that meet certain criteria. For example, they may avoid industries like tobacco, alcohol, or weapons.
• Alternative Investment Funds: These include funds designed for professional investors, such as private equity funds, real estate funds, and other institutional funds.

Benefits of investment funds

Investment funds are a way of investing money with other investors to benefit from the advantages of working as a group. Here are some key benefits of investment funds:

Risk Reduction

Pooling money with other investors can significantly reduce the risks of the investment. Investment funds allow investors to access professional investment managers, who may offer better returns and more adequate risk management.

Economies of Scale

Investment funds benefit from economies of scale, meaning lower transaction costs for individual investors. The collective nature of investment funds also allows for increased asset diversification, reducing unsystematic risk.

Accessibility and Flexibility

Investment funds are easily accessible and can be bought from anywhere in the world through various channels, including brokerage firms, online brokers, banks, and insurance firms. They also offer flexibility in terms of investment amounts, with some funds requiring minimum investments as low as $100.

Professional Management

Investment funds are professionally managed, saving investors time and effort. Fund managers and their teams of analysts conduct research and make investment decisions on behalf of the investors, allowing them to focus on other areas of their lives.

Diversification

Investment funds provide diversification by investing in dozens, hundreds, or even thousands of different securities. This reduces the risk of an individual investor's portfolio being affected by the decline of a few securities.

Affordability and Low Costs

Investment funds can be more affordable to manage than other portfolio types due to their ability to spread costs across a large number of investors. Costs such as transaction fees, annual management fees, and research costs are typically lower for investment funds compared to individual portfolios.

Varied Investment Options

Investment funds offer a wide range of categories and types, allowing investors to diversify their portfolios. Investors can choose from various asset classes, sub-categories, and specialized areas, such as sector funds or precious metals funds.

Suitability for Different Goals

Investment funds can cater to various investment goals, including retirement planning, education funding, and short-term and long-term savings. Different types of funds are available to suit different time horizons and risk tolerances.

Overall, investment funds offer a range of benefits that make them a popular choice for both novice and advanced investors. They provide accessibility, flexibility, diversification, and professional management, all contributing to their effectiveness in helping individuals achieve their financial goals.

Risks of investment funds

Investment funds are a way of investing money by pooling capital from numerous investors to purchase securities. This method of investing offers several advantages, such as broader investment opportunities, better management expertise, and lower fees. However, as with any investment, there are risks involved when investing in funds. Here are some key risks to consider:

Market Risk

Market risk refers to the possibility of a market decline, which can affect the value of investments. This risk is inherent in any investment and can be influenced by various factors, including economic developments, governmental policies, political conditions, regulatory changes, interest rate movements, investor sentiment, and external shocks. These factors can cause fluctuations in the value of investments and impact the performance of investment funds.

Currency Risk

Currency risk arises when there is a mismatch between the currencies involved in the investment. If a fund invests in securities denominated in currencies different from the base currency of the fund or the investor, changes in foreign exchange rates can adversely affect the value of the fund's investments and the income generated from them. Currency fluctuations can lead to losses for investors, especially if their local currency strengthens relative to the currencies in which the fund's investments are held.

Emerging Markets and Political/Economic Risk

Investing in funds with exposure to emerging markets or regions with heightened political or economic issues carries additional risk. These markets and regions may be more volatile and prone to sudden changes due to factors such as unstable governments, less mature financial systems, or unpredictable regulatory environments. As a result, the performance of funds investing in these areas may be more unpredictable and subject to greater risk.

Credit Exposure and Counterparty Risk

Funds may enter into contracts that give rise to credit exposure to counterparties. In the event of a counterparty defaulting on its obligations, the fund may face challenges in exercising its rights related to the investments in its portfolio. This could result in a decline in the value of the fund's position, a loss of income, and potential additional costs associated with enforcing its rights.

Liquidity Risk

Liquidity risk refers to the difficulty in buying or selling investments without causing significant price movements. Investment funds face two levels of liquidity risk. The first relates to the investment manager's ability to buy or sell positions for the fund, and the second pertains to individual investors' ability to buy or sell units in the fund. Illiquidity can impact the fund's ability to meet redemption requests from investors and may result in losses if investments need to be sold urgently.

Fund Manager Performance

The performance of an investment fund heavily depends on the expertise and decisions made by the appointed fund manager. There is a risk that the fund manager may not meet expectations or employ strategies that align with investors' goals. Poor fund management can lead to suboptimal investment choices, affecting the overall performance of the fund.

Diversification Risk

Diversification is a key risk management strategy, and investing in a limited number of assets, a single asset class, or a single market can expose investors to higher risk. Diversification across different asset classes, sectors, and geographies helps mitigate this risk by reducing the impact of any single investment on the overall portfolio. However, even with diversification, there is still a chance of losses, especially if the diversified assets are correlated or affected by similar market forces.

Fees and Costs

Investment funds incur various fees and costs, including management fees, transaction fees, and other operational expenses. These fees can eat into the returns generated by the fund, impacting the overall profitability of the investment. Additionally, some funds may employ strategies that involve frequent portfolio changes, resulting in higher brokerage commissions and transaction costs, further reducing the net returns for investors.

It is important to remember that investing in funds carries inherent risks, and there is no guarantee of returns or capital appreciation. Prospective investors should carefully consider their risk tolerance, conduct thorough research, and seek professional advice before making any investment decisions.

How investment funds work

Investment funds are a way of investing money with other investors to benefit from the advantages of working as a group. These advantages include the ability to hire professional investment managers, who may offer better returns and more adequate risk management, as well as benefiting from economies of scale, i.e., lower transaction costs.

When you put money into an investment fund, you are essentially purchasing shares. These shares can rise or fall in value. You have no control over which companies' shares are purchased, as active investment funds usually have a fund manager who manages every transaction.

Investment funds are typically made up of a mix of investments, which means the fund is diverse in nature. Diversifying is often considered to lower the risk of an investment portfolio, because if one company you have shares in fails, your other shares or investments may be able to make up for that loss.

There are several types of investment funds:

• Open-ended funds: Institutions that offer this type of fund redeem their shares based on each day's closing net asset value (NAV). They are only priced once, at the end of a trading day, and there is no cap on how much an investor can pay in, as they have a theoretically unlimited number of potential shares available.
• Closed-ended funds: This type of fund raises money through an initial public offering (IPO), selling a fixed number of shares at one time, with a cap on how much money can be invested. Once this limit is reached, the fund is closed to further investors, and existing investors can't sell their shares until the fund is liquidated.
• Mutual funds: This is the oldest type of investment fund. The total money invested is pooled and used to purchase baskets of shares, which are priced and sold daily.
• Exchange-traded funds (ETFs): An ETF is a basket of securities that trade on an exchange and track a particular index. When you invest in an ETF, you choose a particular market you want to invest in, and your money is invested in many securities, thus diversifying your portfolio.
• Hedge funds: This type of fund is designed for professional investors with a high-risk appetite. A hedge fund's main goal is to generate big returns, regardless of the direction of the stock market.

Active investment funds usually have a fund manager who makes decisions on where to invest the funds, whereas passive funds do not. Active investment aims to outperform an index or benchmark, while passive investments only seek to track the index they are following. Active investment funds tend to be more expensive than passive funds and offer more flexibility, but they have historically performed worse than passive investments over both short and long periods.

How to choose an investment fund

Investment funds are a way of investing money with other investors to benefit from the advantages of working as a group, such as reducing investment risk and lowering transaction costs. There are several types of investment funds, including mutual funds, exchange-traded funds (ETFs), money market funds, and hedge funds.

• Investment goals and risk tolerance: First, identify your investment goals and risk tolerance. Are you investing for long-term capital gains or current income? Do you need the money for a short-term goal like college expenses or for retirement decades away? Can you tolerate significant swings in portfolio value, or do you prefer a more conservative approach?
• Time horizon: Consider how long you want to hold the investment. Mutual funds have sales charges, so an investment horizon of at least five years is ideal to mitigate the impact of these charges.
• Fund objectives: Each fund must explain its objectives, which can help you decide if it aligns with your investment goals. For example, an income fund manager focuses on companies that pay regular dividends, while a growth fund manager invests in companies expected to grow their earnings over time.
• Risk profile: Assess the risk profile of the fund based on the asset class, the size and success of the companies invested in, and the region. For instance, investing in companies based in developing countries is typically deemed riskier due to the fragility of their economies.
• Fund manager and performance: Evaluate the fund manager's investment strategy and past performance. Review the fund's prospectus, literature, and historical data to understand its investment process and future prospects. Check if the fund has delivered results consistent with general market returns and whether there was unusually high turnover that could impose costs and tax liabilities.
• Expense ratios and fees: Understand the different types of charges and fees associated with the fund, as these will impact your returns. Compare expense ratios, sales fees or loads (which can be front-end or back-end), management expense ratios, and other operating costs. No-load funds don't charge a load fee, but other charges may be very high.
• Diversification: Diversifying your portfolio across different asset classes, sectors, and regions can help manage risk. Avoid putting all your funds into the same fund family to mitigate the risk of internal issues.
• Independent ratings: Check independent fund ratings provided by companies like Morningstar, FE FundInfo, and Square Mile, which analyse performance, risk control, and environmental, social, and governance (ESG) factors.
• Ready-made portfolios: If analysing individual funds seems daunting, consider a ready-made portfolio offered by investment platforms. These package a diversified selection of funds based on your risk level and investment goals.
• Seek professional advice: If you're unsure, consider seeking advice from a financial adviser, who can help you make investment decisions that align with your goals and risk tolerance.

Remember, past performance does not guarantee future results, so focus on choosing funds that are well-positioned for future success rather than solely on historical returns.

Frequently asked questions