What exactly is…an investment fund?

PUBLISHED ON Monday, 16 August 2021

Introduction

A pot of money!

Imagine that several people pool their savings together and invest together, but in different securities. Why? Because it’s easier for several people to gather up a large sum of money to be invested intelligently than it is for one person alone. Also, a large sum lends itself better to being divided up among different investments. This way, it’s easier to cover several types of securities and different markets, which distributes (spreads out) the risk! This distribution of risk is known as diversification.

Sound good?

We think so too! :)

There are as many funds as there are grains of sand on the beach. They differ by the asset class (that is, the type of security) in which the money in the pot gets invested. For example, there are funds that only invest in different stocks or bonds. Other funds purchase real estate or commodities. Many funds mix asset classes, so they’ll buy, for example, half stocks and half bonds. Or something along those lines…there’s a lot of variety.

Active or passive?

An active fund is managed by an expert – a fund manager. They decide which securities to buy with the money in the pot and how much goes to each, and they react to current market trends. Ideally, they make such good investment decisions that the money multiplies considerably.

A passive fund, on the other hand, is not managed by a person; rather, it “technically” tracks an index (the DAX, for example). To put it another way: Based on its composition (i.e., the securities it invests in), the fund takes exactly the same path as the German Stock Index, because it buys precisely the same 30 stocks that comprise the DAX. If the DAX goes up, the fund also goes up. If the DAX loses, the fund goes down accordingly. Here’s another way to think about it: A passive fund rises and falls with exactly the same dynamics as the market segment it tracks.

In comparison to active funds, the fees you’ll have to pay for a share in a passive fund are lower. You’re not paying a fund manager who will intervene if things go south but who, on the other hand, can’t miss the mark because they misjudged, failed to anticipate, or slept through something.

As a general rule, it’s determined beforehand the regions or industries the fund assets will be invested in or which strategies will be employed. However, funds also differ in the way they handle returns. Distributing funds pay the profits out to the investors at specific times. With accumulating funds, the profits flow right back into the pot of money to be invested with what’s there. Just think about the meaning of accumulate (to pile up or to hoard). In the context of economics, it means that the gains (of the company or, in this discussion, a fund) remain with the company, or in the fund, rather than being distributed. It’s a pretty practical thing if you don’t need the money for something else. Profits generated for the company can be invested in exciting projects. And your fund’s profits can simply be allowed to continue to grow beautifully with your investment.

Is a fund a secure investment?

That really depends on what’s there – what’s in the fund. To look at it from the other direction, it depends on what the fund invests in. The value of a fund (and all of its shares) fluctuates with the price of the securities that make it up. Nevertheless, a fund offers more security than an individual stock or government bond or an individual piece of property. The distribution across many different securities reduces the risk of loss.

Additionally, all funds authorized in Germany are subject to the Investment Act, compliance with which is monitored by the German financial supervisory authority BaFin. This law provides all companies that set up and offer funds (called the investment companies) with a framework of conditions (e.g., minimum diversification stipulations), designed primarily to keep investors’ risk (of loss) as low as possible. That’s why a fund may not invest more than 10% of its pot of money in a single security. The five largest (most important) positions may together not make up more than 40% of the fund’s assets.

On top of that, investment companies must publish the key features of their products (i.e., the funds) in accordance with uniform guidelines that apply all across Europe. They must provide clear and comprehensible information as to which investment strategy the fund manager follows, how risky they may be in doing so, how the value of the fund has developed in the past, and…what it costs. This enables us, as outsiders, to better assess different funds and compare them with each other.

Last but not least, the money in a fund is a so-called separate asset. This means that it is held and managed separately from the assets of the investment company itself. If the investment company goes under, no one can access this separate asset. It remains available to the investors.

Flexibility

You can essentially buy or sell shares in a fund any day the financial markets are open (trading days). So you can invest pretty flexibly and access your assets on demand.

An exception is open-end real estate funds – with these, you generally have to observe defined notice periods. Another exception is a fund-based savings plan you take out as a Riester pension plan. They are subject to the rules of a Riester pension – the savings are dedicated to your retirement. You lose the government subsidy as a result of withdrawing the money prematurely – that is, unless you need the money to finance homeownership.

You can take out a fund-based savings plan with many providers relatively easily, often starting from small amounts, such as 25 euros a month. The determined amount then flows into the fund automatically every month. You can often increase the savings rate or decrease it to some minimum any time you need to. You can also temporarily suspend your contributions or terminate the savings plan. Of course you can also invest any given amount of money into a fund at any time instead of or in addition to your contributions. You don’t have to spread your deposits out over time with a savings plan.

How do you find the right fund?

There’s an incredibly large range! Rating agencies, or independent agencies, evaluate funds and the management of them according to defined criteria. This can help you get your initial bearings. The largest agencies are Morningstar, FERI, and Standard & Poor’s.

Financial magazines and online portals in the financial sector also give awards for funds or fund companies, which are another thing you can look at to get yourself oriented. But at the end of the day, you should not make a purchase decision based solely on that. The evaluation criteria are sometimes kind of fuzzy, and not every fund is actually evaluated externally. But to get a rough overview, you can risk a look at the rankings.

Fees

When you buy shares in an actively managed investment fund, you generally pay for the purchase and sale of your shares as well as for management of the fund (basically, the fact that a professional is managing the composition of the fund and achieving the maximum possible profit for you). The fees vary from one investment company to the next. The websites of major financial portals (and of course those of the fund providers themselves) usually list out the costs and fees of funds pretty clearly. This allows you to compare them closely before you take the plunge. :)

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