Investment funds: what they are, their advantages and disadvantages
In the market there are many different products to invest in according to your goals and also depending on your risk profile. Only some of them will be versatile enough to adapt to your circumstances at every stage of your life. Investment funds are one of these.
Don’t you know about them? In this article we are going to talk about what investment funds are, how they work, their advantages and disadvantages.
What is an investment fund?
You may have heard of investment funds and even have an idea about what they are. Now you will really understand what a mutual fund is and how it works.
A fund is a Collective Investment Scheme (CIS; or Institucion de Inversión Colectiva in Spanish), which is a tool that brings together the money of many small savers to invest it in a pool of diversified assets.
To make it easier to understand, an investment fund is a product that combines the savings of many people and then puts them in the hands of a team of investment experts, the fund managers, so that they can make the money grow.
It’s like getting together with several friends to rent a cottage, a yacht or a place for a party, or like when you used to buy a videogame with other friends when you were a kid.
What are the advantages of investing with other people? Although we will go into the characteristics of investment funds a little further on, one of the advantages of these is that you can:
- Gain access to professional managers that would otherwise cost you a lot of money to hire, or would not be worth it.
- Better diversify your investments and have a more balanced portfolio for less money.
- Access asset classes beyond your reach as an individual.
In short, you can do things that you alone with your savings could not, or would not be able to do because of the costs and fees involved.
How does it work and what is it for?
To understand how an investment fund works, you first need to be aware of the three figures that are involved in this product:
- The investor in the fund, in other words, the person who invests in the product.
- The fund manager, who is in charge of investing the investors’ money. These are investment professionals who decide how, when and in what to invest your money. They charge a commission for this work.
- The depositary entity, whose mission is to safeguard your money and, above all, to manage the fund’s liquid assets. They charge a commission for this work.
In essence, as an investor you entrust your money to the fund manager so that they can handle it and achieve a return in line with the fund’s objectives.
From a slightly more technical point of view, these funds work in the following way.
- When you put money into an investment fund you buy one or more units in that fund, just as in a listed company you buy shares.
- The value of these units is calculated by dividing the fund’s assets by the number of units. Its value is always calculated at the end of the day and this rises or falls in line with the assets in which the fund invests. These assets could be stocks, government bonds, other funds, commodities, and so on.
Investing in a fund is not so different from creating your own investment portfolio. The main difference is that here it is experts who try to make your money grow and, as they manage a bigger pot of money, they can implement more efficient and different strategies than you would be able to on your own.
All this, as is logical, entails a series of costs and commissions, which also define how investment funds work.
Investment fund commissions
Costs are inherent to any investment, whether funds, buying shares on the stock exchange, a pension or Unit Linked plan, to name a few.
The basic commissions involved in investment funds are regulated by law and are as follows:
- Management fee, which is the money the manager charges for their work. This commission could be a fixed percentage of the money you have invested, a percentage of the profits (success fee), or a mixture of the two.
- Deposit commission, which is paid to the depository agent.
- Subscription and redemption fee, which is a fee charged by some entities for contracting and selling (redeeming) investment funds.
The following table summarizes the maximum cost of each.
To these fees must be added the fund’s own operating costs. In other words, the fund’s commissions and costs for buying and selling shares or the assets in which it invests.
To find out the total cost of the fund, including these expenses, you can use the TER or Total Expense Ratio, which is usually expressed as a percentage of the fund’s assets. The lower the percentage, the greater the benefit for the participants.
Advantages of investment funds
The characteristics of an investment fund are also reflected in its strengths. These are the advantages that define this type of investment product:
By investing in different types of assets, the funds can be adapted to the needs of all types of investors with different investment profiles: conservative, moderate, risky, specialized in particular themes and sectors…
– Diversification at a lower price
How much money do you have to invest in a fund? Whatever a share costs, basically, which can range from 1,000 to 50 euros although there are also funds with higher investment minimums.
With an equity fund, that 50 euro investment will be equivalent to investing in a portfolio made up of many stocks. For example, you could be investing in the 100 largest companies in the world for 50 euros. Can you imagine how much money you would need to build that portfolio on your own? Probably several thousand euros.
One of the main characteristics of funds is the ability to diversify your investment at a lower cost.
– It is a liquid investment
With an investment fund you can get your money back whenever you want. This makes them very liquid investments.
This liquidity (or lack of it) is one of the risks of investing. Do you want to know why? Imagine you invest your money in a house but you need that money back. It will take several months to get it from the time you put the house on the market until the transaction is completed.
With a fund you can get the money almost immediately. The process is very simple. At the end of the day, the value of each share will be calculated and the redemption order given. In just a few days (the time it takes for the transfer to arrive), you will have the money in your account.
– They are managed by professionals
Behind every mutual fund there is a team of managers who are investment experts and who watch over your investments. This means that your money is in the hands of professionals.
– Funds are regulated
Funds are a safe and regulated investment. On the one hand, they are supervised by the National Markets and Competition Commission (CNMC or Comisión Nacional del Mercado de la Competencia in Spanish).
On the other hand, the Investment Guarantee Fund (FOGAIN or Fondo General de Garantía de Inversiones) covers up to 100,000 euros per participant if the fund should go bankrupt.
In addition, your money is not part of the fund’s accounts. Even if it were to go bankrupt, the assets in which it is invested would still belong to the investors.
– They are transparent
If there is one product where you can thoroughly analyze its performance, it is investment funds.
Firstly, you can clearly see how the fund has performed against its benchmark or reference index (e.g., the average of the funds in its category). Information on how it compares to other similar funds is also easy to find.
Secondly, there are plenty of ratios and indicators that measure the performance of the fund, both the relationship between risk and return, as well as on the value provided by the manager.
– Transfers are tax-free
Taxation is one of the great advantages of investment funds: funds are a product that allows tax deferral.
The key to this tax advantage is that transfers between funds are exempt from personal income tax. If you move your money from one fund to another you will not have to pay taxes when you file your income tax return for the accumulated gains.
This will allow you to take better advantage of compound interest because you only pay taxes at the end.
With other investments such as stocks, every time you sell a stock because you want to change your portfolio, you will have to pay between 19% and 26% to the Treasury. With a fund you can avoid this if you allocate that money to another investment fund.
Disadvantages of investment funds
Like any other investment, funds also have their downside. These are the risks and disadvantages of an investment fund
– Market risk
This is something inherent to any investment. Investing, wherever and whatever your profile, involves market risk.
This risk is the possibility that the value of the asset may fall. For example, if you invest in a stock, that stock may lose value.
– You have to know how to choose
The investment fund market is very broad. There are many funds and not all of them are the same or even good.
There are funds with very high unjustified fees that will eat up your profitability, funds that are only profitable in certain economic scenarios, funds that get a lot of publicity but which have little track record… In short, there are many funds to choose and from these you have to identify the ones that are really worthwhile.
That is perhaps the main disadvantage of the fund market, that the offer is always growing and it is not always easy to decide.
Having a team of experts to help you select these funds can be a good starting point, like with a Unit Linked product, for example.