Information about Collective Investment Scheme

A collective investment scheme is a way of investing money with other people to participate in a wider range of investments than may be feasible for an individual investor and to share the costs of doing so.

Terminology varies with country but collective investment schemes are often referred to as managed funds, mutual funds or simply funds (note: mutual fund has a specific meaning in the US). Around the world large markets have developed around collective investment and these account for a substantial portion of all trading on major stock exchanges.

Collective investments are promoted with a wide range of investment aims either targeting specific geographic regions (e.g. Emerging Europe) or specified themes (e.g. Technology). Depending on the country there is normally a bias towards the domestic market to reflect national self-interest, familiarity and the lack of currency risk. Funds are often selected on the basis of these specified investment aims, their past investment performance and other factors such as fees.

Generic information - structure

Constitution and terminology

Collective investment schemes may be formed under company law, by legal trust or by statute. The nature of the scheme and its limitations are often linked to its constitutional nature and the associated tax rules for the type of structure within a given jurisdiction.

Typically there is:

• A fund manager or investment manager who manages the investment decisions.
• A fund administrator who manages the trading, reconciliations, valuation and unit pricing.
• A trustee or board who safeguards the assets and ensures compliance with the laws and rules.
• The shareholders or unitholders who own (or have rights to) the assets and associated income.
• A "Marketing" or "Distribution" company to promote and sell the fund.

Please see below for general information on specific forms of scheme in different jurisdictions.

Net asset value

The Net Asset Value or NAV is the value of a scheme's assets less the value of its liabilities. The method for calculating this varies between scheme types and jurisdiction and can be subject to complex regulation.

Open-ended fund

An open-ended fund is equitably divided into shares which vary in price in direct proportion to the variation in value of the funds net asset value. Each time money is invested, new shares or units are created to match the prevailing share price; each time shares are redeemed the assets sold match the prevailing share price. In this way there is no supply or demand created for shares and they remain a direct reflection of the underlying assets.

Closed-ended fund

A closed-ended fund issues a limited number of shares (or units) in an initial public offering (or IPO). The shares are then traded on an exchange or directly through the fund manager to create a secondary market subject to market forces. If demand for the shares are high they may trade at a premium to net asset value. If demand is low they may trade at a discount to net asset value. Further share (or unit) offerings may be made by the scheme if demand is high although this may affect the share price.

The added element of market forces tends to amplify the performance of the fund increasing investment risk through increased volatility.

Gearing and leverage

Some collective investment schemes have the power to borrow money to make further investments; a process known as gearing or leverage. If markets are growing rapidly this can allow the scheme to take advantage of the growth to a greater extent than if only the subscribed contributions were invested. However this premise only works if the cost of the borrowing is less than the increased growth achieved. If the borrowing costs are more than the growth achieved a net loss is made.

This can greatly increase the investment risk of the fund by increased volatility and exposure to increased capital risk.

Gearing was a major contributory factor in the collapse of the split capital investment trust debacle in the UK in 2002.

Limited duration

Some schemes are designed to have a limited term with enforced redemption of shares or units on a specified date.

Unit or Share Class

Many collective investment schemes split the fund into multiple classes of shares or units. The underlying assets of each class are effectively pooled for the purposes of investment management, but classes typically differ in the fees and expenses paid out of the fund's assets.

These differences are supposed to reflect different costs involved in servicing investors in various classes; for example:

• One class may be sold through broker or financial adviser with an initial commission (front-end load) and might be called retail shares.
• Another class may be sold with no commission (load) direct to the public called direct shares.
• Still a third class might have a high minimum investment limit and only be open to financial institutions, and called institutional shares.

In some cases, by aggregating regular investments by many individuals, a retirement plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the benefit of their typically-lower expense ratios) even though no members of the plan would qualify individually.

Generic information - advantages

Diversity and risk

One of the main advantages of collective investment is the reduction in investment risk (capital risk) by diversification. An investment in a single equity may do well, but it may collapse for investment or other reasons (e.g., Marconi, Enron). If your money is invested in such a failed holding you could lose your capital. By investing in a range of equities (or other securities) the capital risk is reduced.

• The more diversified your capital, the lower the capital risk.

This investment principle is often referred to as spreading risk.

Collective investments by their nature tend to invest in a range of individual securities. However, if the securities are all in a similar type of asset class or market sector then there is a systematic risk that all the shares could be affected by adverse market changes. To avoid this systematic risk investment managers may diversify into different non-perfectly-correlated asset classes. For example, investors might hold their assets in equal parts in equities, real estate and fixed income securities. If any one of the three is failing, then because each is non-correlated (i.e., behaves independently), by logical extension at least one of the other two is doing well.

Reduced dealing costs

If one investor were to buy a large number of direct investments, the amount they would be able to invest in each holding is likely to be small. Dealing costs are normally based on the number and size of each transaction, therefore the overall dealing costs would take a large chunk out of the capital (affecting future profits). Pooling money with that of other investors gives the advantage of buying in bulk, making dealing costs an insignificant part of the investment.

Generic information - disadvantages

Costs

The fund manager managing the investment decisions on behalf of the investors will of course expect remuneration. This is often taken directly from the fund assets as a fixed percentage each year or sometimes a variable (performance based) fee. If the investor managed their own investments, this cost would be avoided.

Often the cost of advice given by a stock broker or financial adviser is built into the scheme. Often referred to as commission or load (in the U.S.) this charge may be applied at the start of the plan or as an ongoing percentage of the fund value each year. While this cost will diminish your returns it could be argued that it reflects a separate payment for an advice service rather than a detrimental feature of collective investment schemes. Indeed it is often possible to purchase units or shares directly from the providers without bearing this cost.

Lack of choice

Although the investor can choose the type of fund to invest in, they have no control over the choice of individual holdings that make up the fund.

Loss of owner's rights

If the investor holds shares directly, they may be entitled to shareholders' perks (for example, discounts on the company's products) and the right to attend the company's annual general meeting and vote on important matters. Investors in a collective investment scheme often have none of the rights connected with individual investments within the fund.

Style

Investment aims and benchmarking

Each fund has a defined investment goal to describe the remit of the investment manager and to help investors decide if the fund is right for them. The investment aims will typically fall into the broad categories of Income (value) investment or Growth investment. Income or value based investment tends to select stocks with strong income streams, often more established businesses. Growth investment selects stocks that tend to reinvest their income to generate growth. Each strategy has its critics and proponents; some prefer a blend approach using aspects of each.

Funds are often distinguished by asset-based categories such as equity, bonds, property, etc.

Also, perhaps most commonly funds are divided by their geographic markets or themes.

Examples

• The largest markets - U.S., Japan, Europe, UK and Far East are often divided into smaller funds e.g. US large caps, Japanese smaller companies, European Growth, UK mid caps etc.
• Themed funds - Technology, Healthcare, Socially responsible funds

In most instances whatever the investment aim the fund manager will select an appropriate index or combination of indices to measure its performance against; e.g. FTSE 100. This becomes the benchmark to measure success or failure against.

Active or passive management

Investing in real assets is generally accepted as one of the best ways to achieve real investment growth over time.

However, the methods used to make your investment are manifold and often split people into opposing camps. Assuming that it is accepted that a number of different holdings are selected to spread risk then the logical progression is to ask by what method do you select your holdings? At this point when considering Bonds or shares or any other easily definable market then two camps are formed: those who believe that it is impossible to know which stocks will do well and those who believe it is possible to predict which stocks will perform better than others. If you believe it is possible to select the stock which will do well you will actively manage your investment buying and selling upon whichever principles you decide. If you believe it is not possible to predict performance you will purchase your stock upon whichever criteria you feel is appropriate and hold those investments accordingly.

An example of active management success

• In 1998 Richard Branson (head of Virgin) publicly bet Nicola Horlick (head of SG Asset Management) that her SG UK Growth fund would not beat the FTSE 100 index, nor his Virgin Index Tracker fund over three years, nor achieve its stated aim to beat the index by 2% each year. He lost and paid £6,000 to charity.

Alpha, Beta, R-squared and standard deviation

When analysing investment performance, statistical measures are often used to compare 'funds'. These statistical measures are often reduced to a single figure representing an aspect of past performance:

• Alpha represents the fund's return when the benchmark's return is 0. This shows the fund's performance relative to the benchmark and can demonstrate the value added by the fund manager. The higher the 'alpha' the better the manager. Alpha investment strategies tend to favour stock selection methods to achieve growth.
• Beta represents an estimate of how much the fund will move if its benchmark moves by 1 unit. This shows the fund's sensitivity to changes in the market. Beta investment strategies tend to favour asset allocation models to achieve outperformance.
• R-squared is a measure of the association between a fund and its benchmark. Values are between 0 and 1. Perfect correlation is indicated by 1, and 0 indicates no correlation. This measure is useful in determining if the fund manager is adding value in their investment choices or acting as a closet tracker mirroring the market and making little difference. For example, an index fund will have an R-squared with its benchmark index very close to 1, indicating close to perfect correlation (the index fund's fees and tracking error prevent the correlation from ever equalling 1).
• Standard deviation is a measure of volatility of the fund's performance over a period of time. The higher the figure the greater the variability of the fund's performance. High historical volatility may indicate high future volatility, and therefore increased investment risk in a fund.

Types of risk

Depending on the nature of the investment, the type of 'investment' risk will vary.

A common concern with any investment is that you may lose the money you invest - your capital. This risk is therefore often referred to as capital risk.

If the assets you invest in are held in another currency there is a risk that currency movements alone may affect the value. This is referred to as currency risk.

Many forms of investment may not be readily salable on the open market (e.g. commercial property) or the market has a small capacity and investments may take time to sell. Assets that are easily sold are termed liquid therefore this type of risk is termed liquidity risk.

Note that the investor is indifferent to the type of risk, and should not care whether a loss comes from capital risk, currency risk, or liquidity risk - a loss is a loss.

Internationally recognised collective investments

• Exchange-traded funds or ETFs - an open-ended fund traded by listed shares on major stock exchanges.
• Real Estate Investment Trusts or REITs - a close-ended fund that invests in real estate.
• Sovereign investment funds

US specific collective investments

(Click here for US SEC description of investment company types).

• Mutual Funds - Open-ended with a corporate or trust structure.
• Closed-end funds - Closed-ended with corporate structure.
• Unit Investment Trusts - Open-ended with a trust structure and limited duration.

UK specific collective investments

• Investment Trusts - Introduced 1868. Closed-ended with corporate structure.
• Unit Trusts - Introduced 1931. Open-ended with a trust structure.
• Unitised Insurance Funds - Introduced 1970s. Open-ended with a life policy structure.
• OEICs or ICVCs - Introduced 1997. Open-ended with a corporate structure.

Canadian collective investments

• Income Trusts

Ireland specific collective investments

• Common contractual fund

European collective investments

• UCITS
• SICAVs

France & Luxembourg

• Investment funds
• FCP (Fonds commun de placement) (unincorporated investment fund or common fund)
• SICAF (Société d'investissement à capital fixe) (Investment company with fixed capital)
• SICAV (Société d'investissement à capital variable) (Investment company with variable capital)

Netherlands and Belgium

• *BEVEK (Investment Company with variable capital)
• BEVAK (Investment company with fixed capital)
• PRIVAK (Closed-end investment company)

Australian collective investments

• Listed investment company or LIC. Closed-ended collective investment either corporate or trust based. Available since 1928.
• Unit trusts open-ended trust based investments often called Managed funds or unlisted managed funds.

Offshore collective investments

Main article: Offshore fund

• Segregated portfolio company a corporate entity for holding various investments under a single legal entity.

See also

• Closed-end fund
• Exchange-traded fund
• Hedge Fund
• Fund of hedge funds
• Investment adviser
• Investment management
• Financial intermediary
• Financial planner
• Independent financial adviser
• Offshore investment
• Open-end fund

External links

• Multilingual Investment Fund Glossary Links to EU and Member States Regulators
• Answers U.S. SEC Consumer Information
• Investments UK FSA Consumer Information
• Morningstar.co.uk U.K. Fund Information
• Trustnet.com U.K. Fund Information
• FundListings.com U.K. Fund Prices
• FinancialExpress.net U.K. Fund Data and Research

Investment management

Collective investment schemes:  Common contractual funds • Fonds commun de placements • Investment trusts • Hedge funds • Unit trusts • Mutual funds • ICVC • SICAV • Unit Investment Trusts • Exchange-traded funds • Offshore fund • Unitised insurance fund Styles and theory:  Active management • Passive management • Index fund • Efficient market hypothesis • Socially responsible investing • Net asset value Related Topics: List of asset management firms • Umbrella fund • Fund of funds • UCITS