How do investment funds work?

Investment funds are baskets of securities chosen because of their growth prospects by asset management companies that are experts in financial markets. These funds work on a co-ownership basis: when you invest in a fund, you acquire ownership that corresponds to a share of a basket of equities or bonds already selected and actively managed by experts. This means investing in funds can feel safer than buying individual securities, particularly for a novice. Moreover, investment funds tend to have variable capital, which allows you to trade in your securities on a secondary market at any given moment. The funds can take several legal forms, such as the Société d’Investissement à Capital Variable (SICAV) and the Fonds Commun de Placement (FCP). There are three broad categories of fund: passively managed investment funds, actively managed investment funds and hedge funds.

Passively managed funds (index funds) 

These aim to replicate changes in a particular market, region or sector. Passive managers prioritise investment security and buy stocks that make up a stock exchange index. In Luxembourg, for example, the main stock exchange index is the LuxX, which comprises the country’s 10 biggest companies by market capitalisation. The managers adjust the composition of the portfolio based on changes in the chosen index. The level of risk is the same as for the market the funds aim to replicate.

Actively managed funds 

These funds aim to outperform the market. The managers seek to deliver attractive returns by outperforming a benchmark index. They monitor the economic environment and adjust the assets of their fund accordingly. They buy and sell in large quantities in order to maximise capital gains. In this case, the level of risk depends on how the portfolio is broken down into growth stocks, value stocks, small caps and large caps.

Hedge funds demand caution!

Hedge funds involve risky investments in an environment with fewer regulations. Managers seek high returns and use strategies that are not permitted for passively and actively managed investment funds. For example, they can sell short and use debt to increase their investment capacity (leverage). If you are not too averse to risk, investing in hedge funds can be a good source of diversification. If you are, it is probably sensible to avoid them!

Pros and cons of investing in funds

Just like any financial product, investment funds have advantages and disadvantages.

Their main advantage is that they are managed professionally. Experienced professionals work full time on your behalf to manage a portfolio of securities. Investment funds also allow you to diversify your investments. They contain not only a wide variety of securities but also different types of approach: by fund category (equity, bond and money market), economic sector, geographical area, asset size (small and large caps) and level of risk (government debt, high-yield bonds, etc.). Management charges and entry fees tend to be fairly low. Lastly, it is very easy to buy or sell your fund units by getting in touch with the fund’s promoter, via a broker or a financial advisor from a bank or insurance company, or even online.

On the flip side, you have no control over investment funds: you cannot influence purchases and sales, and you never know the exact composition of the fund at any given moment. Moreover, you cannot track real-time changes in the value of your fund units, like you can with shares. When you buy or sell your units, you do not find out their value at the moment of purchase or sale until a few hours later because it takes the fund some time to work out the net asset value.  You are obliged to pay management charges every year, even if the funds in which you have invested deliver negative results.

In summary, investment funds are unquestionably an interesting option but you need to know which ones you should be investing in. Consult your bank advisor and work with them to create your investor profile before making any decisions. This will spare you plenty of setbacks and disappointment.

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