Mutual investment funds

Definition and characteristics

Mutual investment funds are financial instruments used to collect the money of multiple investors and invest it as a single pool in financial assets (shares, bonds, government bonds, etc.), with a view to reducing risks and boosting earnings.

 

They are broken down into many parts, referred to as units, which are subscribed by investors and guarantee equal rights.

 

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Establishment and functioning

Irrespective of the type of mutual fund, all investors participating in them have the same rights: the earnings or losses are in proportion with the amount invested, or better, in proportion with the number of units held.

 

Who manages the funds

There are three main parties participating in mutual investment funds:

 

  1. investors, also referred to as unitholders: they are investors who invest in the assets of the fund by acquiring units using their own capital;
  2. Asset Management Companies (AMC), which are responsible for launching the fund, establishing its regulations and managing its portfolio;
  3. custodian banks, which safeguard the securities, holding cash and cash equivalents. Banks also play a control role.

 

Supervision

Supervision over Asset Management Companies is performed by:

 

  • Consob (the Italian Companies and Exchange Commission), which supervises the fairness of the actions of the AMC and placement agents. It also approves the “prospectuses” that need to be provided to investors;
  • the Bank of Italy, which authorizes AMC activities, approves the “Mutual Fund Management Regulation” and supervises the actions of the Custodian Bank.

 

Fund documentation

The main part of the documentation of a mutual investment fund is the prospectus, or the document that the Management Company is required to prepare and provide to investors.

The prospectus includes:

  • a First Part, which contains information about the legal nature of the fund and the functions of the custodian bank, data relating to the fund characteristics and methods of investment. It also includes the investment objective, the management strategy, the risks associated with the investment, costs, the benchmark, subscription and repayment methods and information about taxation;
  • a Second Part, which provides a comparison between the fund’s historical returns and the benchmark over different periods of time;
  • a Third Part, or the Subscription Form.

 

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Types

Classification

Mutual investment funds can be classified on the basis of a variety of different parameters.

 

An initial distinction regards how profits are distributed:

  • income distribution funds, in which any capital gains may be credited – in full or in part – to the current account of the investor in the form of a half-yearly or annual “coupon”;
  • income accumulation funds, in which the earnings remain within the fund and are credited to the investor when the units are sold.

 

Mutual funds are also broken down between closed-end and open-end funds, in accordance with Regulation of the Ministry of the Treasury (Ministerial Decree 228/1999):

  • closed-end funds call for redemption (by the AMC that established it) of the units subscribed only in specific periods. Those wishing to cash out their investment may therefore do so exclusively by selling units in the market.
  • open-end funds have variable assets (which may therefore increase or decrease from day to day based on new subscriptions or requests for the redemption of units outstanding) and represent the most widespread type of fund.

 

But funds are also broken down into different types depending on the type of investment, the duration and the methods for crediting the profit.

 

Funds also have higher or lower risk profiles: therefore, it is always necessary to turn to specialised operators before subscribing a fund investment.

 

Real estate funds

Real estate funds are closed-end funds used to invest in specific assets, primarily real estate. Indeed, the managers of this fund type are required to use at least two-thirds of the assets in transactions in the real estate market.

 

Alternative funds

These are funds with a portfolio that does not include more traditional instruments, such as liquidity, shares and bonds. Alternative funds are typically used by institutional investors and by private parties with significant liquidity since, although they have potentially high returns, they also carry high risk.

 

Speculative funds (hedge funds)

Hedge funds are characterized by the management strategy adopted, since they use particular hedging strategies and have no restrictions with regard to the subject of the investment. Participation in the fund is generally reserved for institutional or qualified investors or investors with significant available capital. Hedge funds often include lock-up periods of even one year or more.

 

Funds of funds

These are mutual funds whose portfolio consists not of securities, but of units of other funds. Since they can also invest in units of hedge funds, for small investor funds of funds provide direct access to hedge funds, thus getting around the high capital thresholds often required to invest in them.

 

It is fundamental to carefully evaluate the risks inherent in this type of investment.

 

Index funds

Index funds are funds with substantially passive management, that is, an investment strategy whose only objective is to replicate market performance, without seeking to achieve higher returns.

 

ETFs (Exchange Traded Funds)

ETFs are index funds listed in regulated markets, for example the ETFplus (in Italy) or the AMEX (in the US).

 

Pension Funds

Pension funds are technical instruments (belonging to the “private pension system” in Italy) used by workers to have a supplementary pension alongside social security.

 

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Evaluating a mutual fund

Advantages

There are many advantages to investing in a mutual fund. First of all, you can benefit from the skills of the fund manager without venturing out into riskier investments on your own.

 

What’s more, your money is pooled with that of many other investors. Thus, you have access to investment opportunities that would otherwise be unattainable alone. This also means that the risk is distributed: the investment does not depend excessively on a single source, since it is broken down amongst various types of assets.

 

Benchmark

The benchmark is an objective, reference parameter for comparing the performance of the mutual fund and evaluating its risk profile. It is made up of one or more market indexes which summarise the performance of the markets in which the fund invests.

 

For Italian mutual funds, indicating a benchmark is required.

 

The essential requirement that must be met by a reference objective parameter is its consistency with the risk underlying the management of the fund with which the comparison is being made.

 

The other necessary requirements are:

  • transparency: the calculation rules used to construct the benchmark must be clear;
  • representativity: the composition of the benchmark must be consistent with that of the fund assets;
  • replicability: the fund must be made up of financial assets that the investor can, at least theoretically, acquire directly in the market.

 

How much they cost

Investing in mutual funds requires the payment of some expenses that may be broken down into several categories:

  • one-off fees, which are usually applied when a fund is purchased or sold. Since they are not compulsory, they depend on the decisions of the management company.
  • subscription fees, which are calculated as a percentage of the initial investment according to a system of ranges which calls for lower percentages for higher payments, and vice versa. Funds that do not include these fees are referred to as “no load”.
  • recurring fees, which are required for all funds as remuneration for the various levels of fund operations. These are periodic costs that directly impact the result.
  • management fees pay the management company for its fund management and administration activities.
  • performance fees are due to the management company if it achieves returns higher than a pre-established parameter. This is basically a bonus.
  • brokerage costs are instead the costs that the fund incurs for security purchase and sale transactions.

 

Carefully reading the prospectus is recommended to understand all of the instrument’s features and fees.

 

Editor’s note: This article describes mutual funds with particular focus on the Italian regulation. Although there are common EU laws, regulation may vary from country to country. For further information visit your Country’s Central Bank and Conduct Authority websites, or contact your bank or investment banker.

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