Investment Funds: A Quick Comprehensive Beginner’s Guide to Navigate the Legal Landscape in the EU
Introduction
When I mention my specialization in financial markets regulation, I often encounter questions about investment funds—what they entail, how they operate, and the regulatory aspects. Navigating the intricate landscape of the European Union's (EU) investment fund regulations can be complex. While the blog may not cover every detail, its purpose is to furnish readers with a fundamental grasp of the key laws, shed light on the economic needs addressed by investment funds, and outline the different types of funds available.
The world has unquestionably evolved into an interconnected realm, facilitated by the notion that money essentially traverses every boundary, be it national borders, diverse cultures, or languages. Money adheres to a singular rule — the pursuit of opportunities. So, Investment funds basically is just another way for the demand for money to efficiently find supply of money to finance projects and in its turn hopefully can help economic growth.
In the article 'To Invest or Not to Invest,' I highlighted that even if you would not identify yourself as an investor, you might still be one—albeit a silent one. Consequently, we all invest, yet many may not realize the extent to which we are entwined in the multi-billion-dollar business called Investment Funds.
The exception being of course if you are born in less privileged circumstances and live in extreme poverty. In this case you have acces to basically nothing, even not the Liberal, Democratic, Fundamental and Human Rights adherer Fortress Europe, as the chance that you die along the way before reaching Europe, is higher. These unfortunate souls often work in the informal economy – unregistered, unrecognised and unprotected - and facing difficult and dangerous conditions (learn more about World Poverty here). But I am getting of topic here.
Covered in this blog are the following topics:
What is an Investment Fund
Now, picture yourself having saved some hard-earned money and contemplating ways to make it grow. While you can opt to simply deposit it in a bank and earn interest (absolutely nothing wrong with that by the way, as this book ‘ The Psychology of Money, timeless lessons on wealth, greed and happiness’ teaches us) there's a more adventurous option—investing (please be aware that investing carries risks and this blog is to inform and should not be seen as an encouragement or whatsoever to invest).
You might consider putting your money into stocks (acquiring a small ownership stake in a company and receiving dividends in return), bonds (investing in a loan and earning interest), or other assets (like houses). As a fundamental principle of investing is to diversify (simply put, don’t put all you eggs in one basket), ensuring you don't concentrate all your funds in one place, it's nearly impossible for the average person, unless wealthy like Bezos, to access a diversified portfolio of multiple (global) assets.
|=> This is where investment funds come in handy—they pool capital from various investors for collective business ventures.
These funds aggregate capital from multiple investors, enabling them to access a diversified range of assets and investment opportunities that might be challenging to attain individually. Investors benefit from portfolio diversification, and the funds allocate these pooled resources to various businesses.
However, the investment market is as diverse as the global population, whether you are exceptionally wealthy or have modest savings to spare, there is likely an investment product that can meet your specific needs. Thus, if you are affluent like Bezos and seeking a profitable venture to invest in, you have access to more exclusive funds (like private equity (for the more accredited investors)).
In this scenario you would likely be a more active investor in the investment product.
Another scenario is that you are more passively involved, e.g. you set aside some savings for pension through work or buy a pension product or insurance product from an insurance company for your old days. You would then invest through these companies called institutional investors (thus like Pension funds or Insurance Companies). Note that investment funds also can be institutional investors. Because dependent on the role taken on the financial market, one can be an investment fund company providing the investment product or the investor investing in the assets.
The First Investment Fund
I have a fondness for history; it was among my preferred subjects during high school. History provides insights into how humans interact and evolve. This is why I find it truly enlightening to just delve into the history of any subject, whether it's a country (for those interested in the History of Saudi Arabia, you can explore my blog posts under ExploreKSA), an individual, a product, or a concept.
According to the website beursgeschiedenis.nl, the first investment fund in the world was founded in 1744 by the Amsterdam-based realtor and merchant Abraham van Ketwich and he called it ‘Eendragt Maakt Magt’ (‘unity makes strength’). The idea was created against a setback of an economic crisis and the aim was to reduce the risk for individual investors by distribution across different funds. The asset under investment was focused on bonds and was managed by two commissioners. However despite the innovative idea, the fund turned out not to be so successful and liquidated in 1824.
The Dutch are certainly living up to their reputation for having an entrepreneurial spirit, often referred to as "Handelsgeest" in Dutch. As it was also the Dutch who was the first to distribute the coffee, as you can find out in this blog, from the Arabian Peninsula throughout the world.
What type of funds?
The world of investment funds is extensive and diverse, catering to various investor preferences, objectives, and risk tolerances. Whether one seeks simplicity, diversification, long-term growth, or higher-risk opportunities, chances are that you’ll be able to find something that suit your needs. Without being exhaustive, here follows some most common categories of funds.
Mutual Funds: Mutual funds are one of the most popular types of investment funds. They are managed by professional portfolio managers who invest the pooled money in a diversified portfolio of stocks, bonds, or other securities. Mutual funds offer investors the advantage of professional expertise and the ability to access a wide range of investment options with a low initial investment. They suit investors looking for simplicity and a hands-off approach. There are different types of mutual funds. A specific type of mutual fund is e.g. the money market fund, which is an investment vehicle that offers individuals and businesses a convenient way to park their surplus cash. It is an investment fund that pools money from multiple investors to purchase a diversified portfolio of highly liquid and low-risk debt securities. Money market funds are designed to provide stability, liquidity, and competitive yields for short-term investments.
Exchange-Traded Funds (ETFs): ETFs are investment funds that trade on stock exchanges, just like individual stocks. Similar to mutual funds, ETFs offer investors access to a diversified portfolio of assets. ETF shares can be bought and sold throughout the trading day at market prices. These funds provide flexibility, transparency, and potentially lower expense ratios compared to mutual funds. These funds have gained popularity in recent years among the public in the EU and are often promoted by finfluencers. If you have no idea what a finfluencer does? Check out this blog article to find out more.
Index Funds: Index funds are a type of mutual or ETF that track a particular market index, such as the S&P 500. These funds aim to replicate the performance of the index they are linked to, offering investors a low-maintenance, low-cost investment option. Index funds are favored by those seeking long-term growth through passive investing strategies.
Hedge Funds: Hedge funds are investment funds managed by professional fund managers, primarily targeting high-net-worth individuals and institutional investors. Distinguished by their aggressive investment strategies, hedge funds employ various techniques, including short selling, leveraging, and derivatives trading. Hedge funds aim to generate substantial returns even in challenging market conditions, usually charging performance fees. Due to their sophisticated nature, hedge funds often require a significant minimum investment.
Real Estate Investment Trusts (REITs): REITs are investment funds that own, operate, or finance income-generating real estate properties. These assets can include offices, shopping centers, apartments, or even hospitals. By investing in REITs, individuals can partake in the real estate market without personally owning, managing, or financing the properties. REITs offer the potential for steady income, long-term capital appreciation, and diversification.
Private Equity Funds: Private equity funds pool capital from multiple investors to invest in privately-held companies with growth potential. Typically, private equity funds acquire a controlling stake in companies, actively managing and repositioning them for growth before eventually selling their shares for a profit. These funds often boast higher returns but entail higher risk and require longer investment horizons. Private equity funds are usually suitable for accredited investors due to regulatory restrictions.
Venture Capital Funds: Venture capital funds focus on early-stage companies with high growth potential. They provide capital and expertise to startups in exchange for equity ownership. Venture capitalists actively participate in the growth and development of these companies, aiming for substantial returns upon successful exits, usually through initial public offerings (IPOs) or acquisitions. Investing in venture capital funds offers the opportunity to back innovative ideas and entrepreneurial endeavors.
Open- and Closed-End Funds
Another term often heard when it comes to investment funds are whether they are open or closed funds. Different rules may apply to funds based on their open or closed character.
Open-End Funds
Open-end funds are perhaps the more well-known type of mutual funds. These funds are continuously issued and redeemed by the fund management company based on the net asset value (NAV) of the fund. In simpler terms, there is no limit on the number of shares available for purchase by investors. The shares are priced only once a day and also are not sold in the open market but sold back to the company that issued them.
Thus, one key characteristic of open-end funds is their ability to create new shares or redeem existing shares at the end of each trading day at the fund's NAV.
[NAV gives you an idea of what one share of the fund is worth at a specific point in time. If you're an investor, it helps you understand the overall health and value of the fund. If the NAV per share increases over time, it generally indicates positive performance]
Closed-End Funds
Closed-end funds, on the other hand, differ in several ways from their open-end counterparts. Unlike open-end funds, closed-end funds have a fixed number of shares available for purchase, which are issued through an initial public offering (IPO). Once these shares have been sold, new investors cannot buy new shares directly from the fund. Instead, they must purchase existing shares from other investors in the market.
Closed-end funds typically trade on exchanges, just like stocks, and their prices are determined by supply and demand, often deviating from the NAV. As a result, closed-end funds may trade at a premium or discount to their underlying asset value. This can present opportunities for investors to buy shares at a discount, but it also carries the risk of overpaying if the fund trades at a premium.
AuM ( Asset Under Management)
Asset under management (AUM) refers to the total value of assets that a financial institution, such as an investment management company, oversees on behalf of its clients. The AUM figure is a vital metric to gauge the scale and success of an investment firm. It encompasses a wide array of investments, including equities, fixed-income securities, commodities, and real estate, among others. For instance, BlackRock, one of the world's largest investment management companies, had an AUM of approximately over 9 trillion dollars - yes that is 9 with 12 zeros! - in 2023. In comparison, the largest economy in the EU (Germany) in 2023 was approximately over 4 trillion (also dollars). This significant figure showcases the unparalleled magnitude of assets managed by BlackRock, reflecting its dominant position in the investment industry. It is mind-blowing. Other examples of management investment companies with equally mind-blowing number of AUM are BNP Paribas Asset Management, Vanguard Group and AMUNDI.
Master-Feeder Funds
Master feeder funds are investment vehicles that offer a flexible and efficient structure for pooling capital from multiple investors. These funds consist of two components: the master fund, which is typically a large, diversified fund, and the feeder funds, which are smaller, investor-specific funds. The feeder funds channel the investments of individual investors into the master fund, allowing them to benefit from the master fund's economies of scale, diversification, and professional management. This structure offers investors the opportunity to access a wide range of investment strategies and asset classes, tailored to their specific goals and risk appetites. By pooling their resources through master feeder funds, investors can enjoy increased investment options and potentially higher returns while benefiting from the expertise of professional fund managers.
The 2 Key Laws in the EU - UCITS and AIFMD
UCITS Directive (2009/65/EC):
The Undertakings for Collective Investment in Transferable Securities (UCITS) Directive serves as a cornerstone for regulating investment funds in the EU. It provides a comprehensive framework for the management and operation of UCITS funds, which are open-end funds, often referred to as mutual funds. This directive aims to harmonize the regulatory requirements for UCITS funds across EU member countries, allowing for a single market for investment funds.
AIFMD (Alternative Investment Fund Managers Directive) (2011/61/EU):
While UCITS funds cover retail investors, the AIFMD focuses on alternative investment funds (AIFs) aimed at professional and qualified investors. This directive introduces a regulatory framework for alternative investment fund managers (AIFMs), ensuring an appropriate level of investor protection, risk management, and transparency. AIFMs must obtain authorization from their home EU member state while complying with key provisions related to disclosure, capital requirements, risk management, and the appointment of a depositary.
Other Applicable Frameworks
Prospectus Regulation (EU 2017/1129):
The Prospectus Regulation sets the rules for the issuance and publication of prospectuses when offering securities to the public or admitting them to trading on a regulated market. Investment funds issuing securities, such as units or shares, are required to publish a prospectus containing detailed information about the fund, its investment strategy, risks, and financial statements. This regulation aims to enhance investor protection by ensuring that investors have access to reliable and transparent information.
PRIIPS (Regulation (EU) No 1286/2014):
The PRIIPs (Packaged Retail and Insurance-based Investment Products) regulation is a crucial framework with the aim of standardising pre-contractual information on “packaged financial products. This includes financial products like ETFs. This regulation mandates thorough disclosure of information about investment products, helping retail investors - like you and me - make well-informed decisions. The result of these rules are that funds are required to produce a Key Information Documents (KIDs) that provide essential details such as risk profiles, performance scenarios, and costs.
MiFID II (Markets in Financial Instruments Directive II) (2014/65/EU):
Although not exclusively focused on investment funds, MiFID II has a significant impact on the distribution of investment funds within the EU. It establishes rules for the provision of investment services and activities, including the marketing and sale of investment funds. MiFID II requires investment firms to assess the suitability and appropriateness of investment products, including investment funds, for their clients. It also enhances transparency and investor protection by regulating the disclosure of costs, charges, and fees related to investment products.
In addition to these rules, the EU has also established regulations for specific types of funds, serving particular purposes, such as boosting the EU market or encouraging specific types of investing. Examples include:
European Venture Capital Funds Regulation (EuVECA): Is designed to facilitate the raising of capital by venture capital funds in the EU. It provides a harmonized regime for the registration and operation of venture capital funds to encourage investment in small and medium-sized enterprises (SMEs) and startups.
Money Market Fund Regulation (MMF): The MMF Regulation aims to enhance the stability and resilience of money market funds. It establishes uniform rules for the operation and supervision of money market funds in the EU, addressing issues related to liquidity, credit quality, and transparency.
European social entrepreneurship funds Regulation (EuSEF): EuSEF is designed to support the financing of social enterprises, which are businesses that have a primary goal of achieving a social impact. The regulation establishes a framework for the creation and operation of European Social Entrepreneurship Funds, encouraging investment in projects with a social focus.
European long-term investment funds Regulation (ELTIF): ELTIF is aimed at fostering long-term investments in the EU economy. It provides a framework for the creation of investment funds that focus on investing in long-term projects such as infrastructure, real estate, and small and medium-sized enterprises. ELTIFs are intended to attract capital for projects that contribute to economic growth.
Please be aware that financial rules and regulations in the EU evolve rapidly, so for the latest updates, it's essential to check the official website of the EU!
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