We’ve all heard about them. Still, as ubiquitous as they are, how investment funds work remains a mystery for many people. Considering how vital investment funds are to us as people living abroad, we want to demystify these popular financial products.
What is an investment fund?
An investment fund is a collection of money from multiple investors to purchase a basket of different securities and investment products.
Let’s break that down a little bit.
In the spirit of “strength in numbers,” people pool their money so they can make investments together.
With this money, these people will buy a bunch of securities — a fancy way of saying stocks and bonds — or other assets, like real estate.
We call this collection of investments a “basket.”
Because a group of people can buy more assets together than individually, this collective investment offers many benefits.
These advantages include:
- Risk reduction since the basket invests in many different securities, the impact of asset harms the overall investment decreases
- Lower costs as the fund managers buy and sell the assets in bulk, there are considerably fewer transaction fees involved.
- Exclusive access to investments and strategies not readily available to individual investors.
- Professional management as the people running the fund are qualified financial professionals.
Put together, these collective investments offer investors of all types a low(er) cost way to invest money.
It’s all funds and gains (until someone takes a loss).
They can invest in different sized companies or “caps” within the exchanges. Likewise, they can follow different sectors, such as tech companies, consumer goods manufacturers, or healthcare.
Some funds invest in real estate, such as office buildings and shopping malls. Others will invest in commodities like gold and silver.
Others still will make more exotic investments, using borrowed money and complex financial instruments.
Since funds bundle individual assets together, funds are often called “wrappers.”
In any case, the fund’s overriding objective is to give investors a return on their investment. If a fund fails to meet this objective, investors will leave (if possible), and the fund will subsequently close.
Types of investment funds
There are many different types of funds. Some of the most popular ones that you’ve (probably) heard of are:
- Mutual funds
- Index funds
- ETFs or “exchange-traded funds.”
- Multi-asset funds
- Pension funds
- Unit trusts
- Open-ended funds
- Closed-ended funds
- Hedge funds
- Private equity funds
Impressive, right? What’s important to remember, though, is that while these are all funds, they are not created equal. Each type has a different legal structure, rules, transparency, and operating methods.
In Europe, investment funds fall under one of two categories:
- Undertakings for Collective Investment in Transferable Securities or “UCITS” and;
- Alternative Investment Funds (AIFs).
This European structure is gaining popularity outside of the EU, particularly in Asia, with many countries adopting similar rules. Fund companies benefit as they can offer the same fund in different countries without high extra costs, which saves investors money.
Unsurprisingly, the Americans do it a bit differently, in part because their laws pre-date the European ones. As a result, many non-American investors cannot easily invest in US-based funds.
However, most fund companies offer similar funds located outside of the United States. In turn, non-Americans can invest broadly in the US.
The best investors (and the ones who can sleep at night) invest within their risk tolerance. Do you know yours?
How investment funds work
Even though there are many different structures, the general operating guidelines are the same.
An investment management company proposes the creation of a fund. The reasons for doing so are for either existing or perceived demand.
The firm decides on a strategy to follow and what assets to invest in. First, they set an objective — for example, invest in companies making electric vehicles and self-driving cars.
Then, they will decide which companies’ shares they’ll buy within that target.
From there, the firm sets a benchmark. This step is crucial as it allows investors to measure their fund’s performance versus a quantifiable metric. Many funds use an index as a benchmark, like this one, since it accurately represents the investment target. Funds also combine indexes, depending on their goals.
Finally, the management company defines the rules for managing the fund. These include when to make adjustments and whether or not to reinvest the profits.
The investment management company then finds a bank and broker to manage the ‘logistics’ of the fund. The bank acts as a custodian for the fund. Their job is to hold the investment basket and take care of the individual securities.
Likewise, the fund can use a broker to buy and sell the assets within the basket. Some types of funds, like ETFs, rely on this broker daily to keep the fund performing properly.
Finally, they’ll set the costs related to the fund. These costs include:
– Fees for joining and or leaving the fund and;
– Ongoing management charges.
Once they set the objectives, the company does two things:
- Starts a marketing campaign to get the initial investors
- Appoint a manager to create and manage the fund.
The first step is self-explanatory; funds need investors’ money to exist. The second step is equally important.
The manager will oversee the fund’s operations. It is his or her’s job to monitor and adjust the fund’s performance continuously, as well as to increase or decrease the basket size if investors input or withdraw their money.
The manager will not act alone. He or she will run a team of analysts who work closely with the broker, custodians, and operations teams. Together, they work to manage and grow the fund successfully.
Wrapping it up
Funds offer investors a lower-cost way to grow their money. Compared to holding and managing a portfolio of individual stocks, people and companies alike outsource this role to funds.
That said, there are a few points to keep in consideration.
First and foremost, no two funds are created equally. Some funds, like ETFs, are transparent and low cost. Other funds like hedge funds and alternative investments come with strict rules on when investors can take back their money.
Mutual and pension funds don’t have to disclose their investments. Often, you can read a pension fund’s documents, and it will only tell you the ten largest investments it makes. The rest is for you to figure out, leaving you (and your money) at the mercy of the manager.
Even within these fund types, cost and quality can vary significantly. Some are low cost and perform well. Others are both expensive and underperform their competitors.
Funds can and do fail, and for many reasons. Some of the most common causes of failure are poor management decisions, a lack of investors and bad luck.
Finally, the tax investors pay depends on the fund’s structure and “home country.”
These considerations only complicate the decision-making process for people living abroad.
For expats and digital nomads, choosing the right fund for the right strategy means taking a borderless approach to investing. Any person struggling to make sense of it all should speak with an investment advisor. These professionals can help build an investment strategy tailor-made to your global needs.
In any case, whatever you do investment-wise, have fund doing it, wherever you may be.
…We’ll show ourselves out.
Abroaden is a company for expats, digital nomads and other world citizens looking for low-cost and transparent financial advice and investment management.
Note that this article is for information and educational purposes only. It does not constitute financial advice.