When you invest in an investment fund, you invest alongside other investors. There are many types of investment funds and the legal framework for investment funds varies throughout the world. The terminology for this type of investment scheme also varies, with terms such as investment pool, collective investment scheme, managed fund, or collective investment vehicle sometimes being used interchangeably with investment fund.
There are several reasons why people invest in investment funds.
- When a lot of people with small amounts of money to invest pool their resources together instead of investing as individuals, a more diverse investment portfolio can be created.If this reason is important to you, our advice is that you carefully check the diversification level of the investment fund you are interested in. Not all investment funds are highly diversified. To achieve a really high degree of diversification, the fund should ideally invest in several different asset classes and market sectors.
- An investment fund can be managed by a professional investment manager.Before investing in an investment fund, always check how the hired investment manager is paid. Will the manager take fund assets at a fixed percentage each year? Is there a variable involved?
Even a seemingly small fee that is detracted from the fund each year can have a large economic impact in the long run. That is because you are not just losing that money, you are also losing any profits that it could have yielded if it hadn’t been used to pay a fund manager. And those profits could have been used to generate even more profits, and so on.
- Economies of scale can lead to lower transaction costs.
- Time efficient for the investorYou only decide which investment fund to invest in, you don’t continually have to make a myriad of small decisions.
While some people enjoy making decisions about the day-to-day management of their investments, there are also those who don’t. One way of hiring someone else to make these decisions is to invest in an investment fund.
There are also investors that likes to balance their own individually managed investment portfolio with investments in investment funds.
Loss of owner’s rights
When you purchase a share directly, you attain the right to attend the company’s general meeting and vote. If you invest through an investment fund instead, you do not gain any such rights. So, even if the investment fund holds big amount of shares in Company XYZ, you don’t have any right to vote or even be present at Company XYZ’s general meeting.
Open-ended or closed-ended?
An open-ended investment fund is continuously open for new investments. The fund is divided into shares/units. Each time someone buys into the fund, new shares/units are created. The price of a share in the fund is always based on the fund’s net asset value.
A closed-end fund on the other hand starts by making an initial public offering or a private placement of shares/units, and the number of shares/units issued at this point is limited. New shares/units will not be created every time someone buys into the fund. Since the number of shares/units are limited, you may have to pay a premium to convince someone to sell their shares/units to you, i.e. you have to pay more than what a strict net asset value based valuation would say the value of a share/unit is. It is simply a question of supply vs demand. If demand is low, you may be able to purchase shares/units in the fund for a price that is below the price stipulated by a net asset value evaluation.
Even for a closed-end fund, it is possible to create more shares/units. This is quite common when a closed-end investment fund becomes very popular. The creation of new shares/units cause a drop in the share/unit price, since the difference between demand and supply decreases.