Investment fund

Investment funds can be named in different ways, often it’s easy to refer to them as investment pools, collective investment vehicles, collective investment schemes, managed funds, or even simply funds.

According to Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 the regulatory term is “undertaking for collective investment in transferable securities" or "short collective investment undertaking”.

What are investment funds?

Investment funds, according to the European Union Commission, are financial institutions designed with the purpose to pool investors’ capital and invest it collectively in a portfolio of financial assets like stocks, bonds, and other securities.

The directive on undertakings for collective investment in transferable securities (UCITS) is the main European framework covering collective investment schemes.

Investment funds are considered an important instrument in helping people build up their personal savings, whether it be for retirement or major investments. They are also important because permit the borrowing of institutional and individual savings to businesses and initiatives that support growth and employment.

Looking at M. Kacperczyk et al. works is easy to realize that when you invest in an investment fund you are not investing by yourself, but you are investing alongside other investors. This simple fact gives you the advantages of working in a team, like a significantly lower risk of the investment.

Other advantages deriving from investing alongside other people in an investment fund are:

• the possibility to hire professional investment managers, who might provide greater returns and more effective risk management;
• the ability to take advantage of economies of scale, i.e., lower transaction costs;
• the possibility to improve asset diversification to reduce some unsystematic risk.

Investment funds differ from each other in many characteristics.

According to A. Ganchev, Investment Funds can be held by the public, such as a mutual fund, exchange-traded fund, special-purpose acquisition company, or closed-end fund, or they may be sold only in a private placement, such as a hedge fund or private equity fund. Furthermore, they can be specialized vehicles such as collective and common trust funds, which are unique bank-managed funds designed primarily to combine assets from qualifying pension plans or trusts. Or they can even be of governmental property like the sovereign wealth funds.

Usually, funds are selected by investors basing their decision on the specified investment aims, their past investment performance, and other factors such as fees.

The importance of Investment Funds in today's markets

Investment funds are becoming more and more important and control an increasingly vast amount of wealth. Looking to John Morley 2013, by some estimates, the various types of funds collectively hold about $18 trillion in the United States. They hold more assets than the commercial banking system and almost enough assets to equal the value of all domestic equity securities listed on the New York Stock Exchange and NASDAQ combined.

In Europe, approximately 75% of all collective investments made by small investors are made through undertakings for collective investment in transferable securities.

Types of Investment Funds

Almost all of the businesses that we typically think of as investment funds separate their funds and managers. But despite this commonality, we have a wide range of different types of investment funds.

The largest category of funds is the “mutual” fund (John Morley 2015). Mutual funds are usually defined as pools of stocks, bonds, and other investment securities. The general public can purchase shares from mutual funds to invest in these pools for their retirement or other goals. These types of funds are required to register with the SEC and comply with the ICA since they sell their shares extensively to the general public.

Mutual funds allow shareholders to “redeem” their shares. In other words, shareholders have the option to exchange their shares, returning them to the fund, for the cash value of their shares. This amount is equivalent to the value of the part of a fund's net assets that correspond to each share. Shareholders of mutual funds can normally redeem any day.

“Exchange-traded” funds (ETFs) are a special kind of mutual fund.

Mutual funds are sometimes called “open-end” funds to distinguish them from “closed-end” funds.

Closed-end funds are similar to mutual funds in many aspects. They must comply with the ICA since they are pools of investment securities that sell interests extensively to the general public. The main difference is that closed-end funds do not permit shareholders to redeem. Closed-end fund shareholders dispose of their shares by selling them on stock markets as they might do with the shares of operating companies.

“Hedge funds", like mutual funds, are pools of investment assets. However, they only sell securities to a small number of institutional investors and wealthy individuals. Therefore, hedge funds are exempt from SEC registration requirements and ICA compliance. Hedge funds allow their shareholders to redeem their shares. However, they typically allow redemptions only once per month or once per quarter, rather than daily as mutual funds do (Morley and Ganchev).

“Private equity” funds like hedge funds sell only to wealthy individuals and institutions and therefore do not register with the SEC or comply with the ICA. But they do not give redemption rights. Instead, they last for a defined amount of time, typically five to ten years and after that, they disperse their assets or sell them and distribute the revenues to investors.

Usually, to refer to “private equity” funds it’s easy to ear other titles that more specifically describe the funds’ investment strategies. For example, “Venture capital” funds, tend to invest primarily in companies that are relatively new and risky; “Buyout” funds tend to buy large and controlling stakes in a small number of established operating businesses. Other types of private equity funds invest in real estate, distressed debt, and other asset classes.

Another is the "Strategic Investment Fund" or "SIF", which according to Håvard Halland et al. (October 2016) is a special-purpose investment fund that exhibits some specific characteristics. SIFs typically are sponsored and/or fully or partly capitalized by a government, by several governments, or by government-owned global or regional finance institutions; they invest to achieve financial and economic returns following a double bottom line. This kind of fund tries to attract private funding by participating in co-investments at the fund or project level. They operate as expert investors on behalf of their sponsors; provide long-term capital, primarily in the form of equity, with the option to also invest in debt or quasi-equity; and are structured as investment corporations or investment funds.

Strategic Investment Fund tend to invest in infrastructure projects and/or other funds, but they may also include investments in private equity and venture capital funds for small and medium enterprises. According to Clark and Monk's (2015) definition: SIFs are publicly sponsored commercial investment funds that combine financial performance objectives with development objectives.

The Separation of Funds and Managers

In the article “The Separation of Funds and Managers: A Theory of Investment Fund Structure and Regulation” by John Morley (2013), the author suggests that the essence of investment funds and their regulation lies not just in the nature of their assets or investments, but also in the nature of their organization.

As said previously an investment fund is not simply an enterprise that holds “investments”, but it holds investments in a particular way. Investment fund adopts a pattern of organization called the “separation of funds and managers” (J. Morley).

These enterprises place their portfolio securities, currency, and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space, and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. For instance, the management company runs several mutual funds under its brand name. Each fund is a separate entity with separate owners, just like the management itself is a distinct company. In this way investment companies also tend to drastically restrict the amount of influence fund investors have. The management firm and staff of a conventional hedge fund, for instance, cannot be fired or replaced—not even by a unanimous vote of the fund's board and equity holders.

This pervasive feature, always according to J. Morley's publication, is often viewed as a kind of scam, depriving investors of the right to control their managers and share in their managers’ profits. But in fact, the separation of funds and managers is the pattern that benefits fund investors.

It limits their ability to influence managers and their exposure to managers’ profit and liabilities. For three reasons, these constraints are especially effective in investment funds. First, the majority of fund investors have special rights of exit and are safeguarded by unusually strong incentive compensation systems. As a result, management company investors can effectively exercise more control than fund investors can. Second, usually fund investors have strong desires for precision in the tailoring of risk. They only want exposure to the risks associated with investment assets, not the hazards associated with management operations. Third, by managing numerous funds at once, fund managers can obtain economies of scope and scale.

This simultaneous management is only possible when the relationship between funds and managers is strictly separated, limiting fund investors' control rights and exposures to managers' earnings and liabilities.

So, in terms of rights and risks, fund investors look more like buyers of products or services than investors in ordinary companies. As product buyers can “exit” by refusing to buy more products, investors in funds often can exit by taking their money out and refusing to pay managers' fees. Like consumers do not own or influence the manufacturers of the products they purchase, fund investors do not own or have control over their management businesses, also because fund managers operate simultaneously multiple funds.

References

• Clark, Peter B., and Ashby Monk. (2015). Sovereign Development Funds: Designing High-Performance, Strategic Investment Institutions. Stanford University, Stanford, California, 1-4.
• Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securi-ties (UCITS). Official Journal of the European Union (17/11/2009).
• Ganchev, A. (2015). Institutional Characteristics of Hedge Funds. Tsenov Academy of Economics, Business management, 20-38.
• Halland H., Noël M., Tordo S., Kloper-Owens J. (October 2016). Strategic Investment Funds: Opportunities and Challenges. World Bank Policy Research Working Paper No. 7851, 1-8.
• Investment funds, European Commission (14/11/2022).
• Kacperczyk M., Van Nieuwerburgh S., Veldkamp L. (March, 2016). A Rational Theory Of Mutual Funds’ Attention Allocation. Econometrica, Vol. 84, No., 571–626.
• Morley J. (2013). The Separation of Funds and Managers: A Theory of Investment Fund Structure and Regulation. Yale Law Journal 1228, Virginia Law and Economics Research Paper No. 2013-04.

Author: Paolo Baruffi

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