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Collective investment scheme

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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 proportion 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.

Contents

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:

Please see below for detailed 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 (or units) 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.

As is no doubt clear, 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:

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. 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-correlated asset classes. For example, investors might hold their assets in equal parts in equities, real estate and fixed interest 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

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 investement 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

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:

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 can therefore may take time to sell. Assets that are easily sold are termed liquid therefore this type of risk is termed liquidity risk.

Internationally recognised collective investments

US specific collective investments

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

UK specific collective investments

Canadian collective investments

Ireland specific collective investments

European collective investments

French Netherlands and Belgium

Australian collective investments

Offshore collective investments

See also

External links


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

 

From Wikipedia, the Free Encyclopedia. Original article here. Support Wikipedia by contributing or donating.
All text is available under the terms of the GNU Free Documentation License See Wikipedia Copyrights for details.

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