Chapter 7 · Investment Funds

A pooled vehicle in which money from many investors is combined and managed by a professional manager according to a stated investment objective. Investors buy units/shares in the fund; the manager invests the pool.

1. Diversification — small investor gets exposure to many securities
2. Professional management
3. Economies of scale — lower transaction costs per pound invested
4. Access to assets with high minimums (e.g. corporate bonds, private markets)
5. Administration — record-keeping, tax reporting handled

• Ongoing management fees (0.05% for index ETFs up to 1.5%+ for active retail funds)
• No direct control over individual holdings
• Possible tax inefficiency in some jurisdictions
• Manager risk

Manager makes discretionary decisions — security selection, market timing, sector tilts — aiming to OUTPERFORM a benchmark or generate absolute return. Typically higher fees.

Fund aims to MATCH a stated benchmark index (S&P 500, FTSE All-Share, MSCI World). Constructed by replicating index constituents. Lower fees. Dominated by Vanguard, BlackRock (iShares), State Street.

Tracking difference: simple return gap between fund and benchmark over a period (fund returned 9.8% vs benchmark 10.0% → 0.2% tracking difference).

Tracking error: standard deviation of those return gaps — a measure of CONSISTENCY of tracking.

Both metrics matter: TD measures total cost drag; TE measures stability.

SPIVA (S&P Indices Versus Active) scorecards consistently show that 80–95% of large-cap US equity active managers underperform the S&P 500 over 10–15 year horizons, after fees. Stronger evidence in efficient large-cap markets; less strong in specialist / illiquid segments.

A rules-based approach that constructs portfolios weighted by identified factors (value, momentum, quality, low-volatility, size) rather than pure market cap. Sits BETWEEN pure passive (cap-weighted index) and active (discretionary picks). Lower fees than active, tilted exposures.

Number of units/shares VARIES — new units are CREATED when investors buy in, and CANCELLED when investors redeem. Fund size grows and shrinks with subscriptions/redemptions.

Units bought and sold DIRECTLY with the fund manager, at NAV. NOT traded on a stock exchange.

NAV per unit = (Fund assets − liabilities) ÷ Units in issue.

Typically calculated ONCE PER DAY at a stated "valuation point". Investors deal at the NEXT NAV (forward pricing) — you don't know exactly what you'll pay when you place the order.

The US name for an open-ended pooled investment vehicle. Regulated under the Investment Company Act of 1940 by the SEC.

UK open-ended vehicle in trust form. Trustee holds assets on behalf of unit-holders; a separate fund manager makes investment decisions. Largely replaced by OEICs in modern UK retail.

UK open-ended fund in corporate form (rather than trust). Single-priced units (one NAV), depositary holds assets, board of directors oversees the manager. OEICs largely replaced unit trusts in the UK during the 2000s–2010s.

SICAV (Société d'Investissement à Capital Variable) — corporate-form open-ended fund. Common in Luxembourg, France, Belgium, Italy.

FCP (Fonds Commun de Placement) — unincorporated co-ownership / mutual fund. No separate legal personality; managed by a management company. The trust-equivalent in jurisdictions that don't use trusts.

UCITS = Undertakings for the Collective Investment in Transferable Securities. An EU directive setting standards for retail-distributable open-ended funds — rules on diversification, eligible assets, leverage, liquidity, disclosure.

A UCITS fund authorised in one EU country can be distributed in all others ("passporting"). De facto global retail standard — UCITS funds are sold in MENA, Asia, and LatAm.

Liquidity mismatch: daily-dealing fund + multi-week-to-sell underlying property. When redemptions exceed the fund's cash buffer, the manager suspends dealing rather than force fire-sales of property.

UK examples: 2008, post-Brexit 2016, COVID 2020, 2022 rate shock. Why the FCA has pushed for "Long-Term Asset Funds" (LTAFs) — open-ended but with notice periods.

A LISTED COMPANY with a FIXED number of shares in issue. Investors buy and sell those shares on a stock exchange like any equity. Fund's capital is "closed" — doesn't grow or shrink with investor flows.

A UK investment trust is a public limited company (PLC) listed on a stock exchange. Governed by company law + a board of directors independent of the manager. The "trust" name is historical — it is NOT a legal trust in the same sense as a unit trust.

Because shares trade on exchange at prices set by supply/demand, the market share price can differ from NAV.

Share price < NAV = trading at a DISCOUNT. Share price > NAV = trading at a PREMIUM.

Discounts widen in stressed markets (forced retail selling), narrow (or flip to premium) when the fund is in demand or the manager is hot. This is a defining feature of closed-ended structures — ETFs and OEICs generally don't have persistent discounts.

Investment trusts can BORROW to invest more than shareholders' equity. Gearing amplifies both gains and losses.

Open-ended UCITS funds are HEAVILY leverage-restricted. Why ITs typically trade more volatilely than equivalent OEICs.

Closed-ended capital is "permanent" — there are no redemption demands forcing the manager to sell illiquid assets at distressed prices. Critical for holding infrastructure, private equity, direct property.

Listed, closed-ended vehicle that owns and manages income-producing real estate. Required to distribute a high proportion (typically 90%) of taxable rental income as dividends. In exchange, corporation tax is largely avoided at the fund level.

Major REIT markets: US, UK, Singapore, Japan, Australia. Liquid + low-min way to access property.

Investment trust boards may act to narrow persistent discounts via:

• Share buy-backs — reduce shares in issue, support share price, typically NAV-accretive
• Tender offers — offer to buy back a portion at close to NAV
• Continuation votes — periodic shareholder decision points on whether the trust should keep operating

A pooled investment fund (typically open-ended in structure) whose SHARES trade on a stock exchange like equities. Combines the diversification of a fund with the intraday liquidity of a share.

Most ETFs are passive index-trackers; active ETFs are growing.

Authorised Participants (APs) — typically large banks — can exchange baskets of underlying securities for newly-issued ETF shares (CREATION) or return ETF shares for baskets of securities (REDEMPTION).

If the ETF price rises meaningfully above NAV, APs create new shares (arbitraging the gap). If it falls below, APs redeem. This keeps the trading price closely tied to NAV. Different from closed-ended ITs, which have no such mechanism — hence persistent discounts.

ETF directly HOLDS the actual constituents of the index. Two flavours:

• Full replication — holds every index constituent in index weight (works for liquid large indices like S&P 500)
• Sampled replication — holds a representative subset (used for very broad indices like FTSE All-World where full replication is operationally costly)

Most retail ETFs use physical replication.

ETF enters a total-return swap (TRS) with a counterparty — typically a major bank — who delivers the index total return. ETF holds a collateral basket + the swap exposure.

Pros: very accurate tracking, can access hard-to-reach indices. Con: counterparty risk if the swap counterparty defaults. UCITS rules cap swap counterparty exposure at 10%. More common in Europe than the US.

Pooled, actively-managed fund typically restricted to PROFESSIONAL / institutional investors. Uses a wide range of strategies — long/short, leverage, derivatives, illiquid assets — often aiming for absolute return regardless of market direction.

Classic hedge fund fee structure:

• ~2% annual management charge (AMC) on assets under management
• ~20% performance fee on profits above the high-water mark and/or hurdle

Eroded over time under competitive pressure — many large hedge funds now charge 1–1.5% + 15–20%. Multi-strat funds sometimes charge much higher pass-through fees.

Performance fees are only charged on gains ABOVE the investor's previous PEAK NAV. If the fund falls 20% then rises 20%, no performance fee until the original peak is recovered. Prevents the manager being paid twice for recovering the same losses. Industry standard since the 1990s.

Hedge funds restrict investor liquidity to avoid forced fire-sales during stress:

• Lock-up period: no redemption for 1–3 years after initial investment
• Notice period: e.g. 90 days' written notice before a redemption date
• Redemption gate: caps total redemptions per period (e.g. max 25% of fund in any quarter)
• Side-pockets: illiquid positions ring-fenced from normal redemption

• Equity long/short — Citadel, Lone Pine
• Global macro — Bridgewater, Brevan Howard
• Event-driven — Elliott, Third Point
• Merger arbitrage
• Relative value / fixed income arb
• Quantitative / managed futures — Renaissance, AQR, Man AHL
• Distressed debt — Apollo (originally), Oaktree

UCITS-wrapped funds that deliver hedge-fund-style strategies (long/short, macro, market neutral) with DAILY liquidity. Trade-off: UCITS leverage and concentration limits constrain replicating the true hedge fund. Performance often falls short of the unrestricted version — but cheaper, more transparent, more accessible.

Investment in PRIVATE (unlisted) companies — typically taking controlling or large minority stakes, holding for several years, improving operations, and exiting via sale, IPO, or recapitalisation.

Sub-types: Buyout (large mature companies — KKR, Blackstone, Apollo), Growth equity (mid-stage scaling), Venture capital (early-stage startups).

PE funds are structured as closed-ended Limited Partnerships with a fixed life (typically 10 years):

• Limited Partners (LPs) — the investors (pension funds, endowments, sovereign wealth funds, family offices). Provide the capital.
• General Partner (GP) — the fund manager. Sources deals, executes them, manages portfolio, delivers exits.

LP capital is COMMITTED, then DRAWN DOWN by the GP over the investment period (~5 years). Distributions come back over years 5–10 as exits happen.

The GP's incentive share of profits — typically 20% of profits above an 8% IRR hurdle. Aligns manager and LP outcomes. Major source of GP economics.

Also a longstanding tax debate — carry has historically been taxed as capital gains in the US/UK, controversial politically.

PE funds show NEGATIVE returns in early years (fees being charged, portfolio companies being repositioned, no exits yet). Positive returns and exits build in years 4–10 as investments mature.

Cumulative NAV plotted over time resembles a "J". Implication: PE returns must be measured over the FULL fund life, not interim NAV.

IRR (Internal Rate of Return): annualised, time-weighted. Penalises slow capital deployment; rewards fast distributions.

MOIC / TVPI (Multiple on Invested Capital / Total Value to Paid-In): total cash returned ÷ cash invested. Top PE funds aim for 2–3× MOIC and 20%+ IRR over the fund life.

• Trade sale — sold to a corporate / strategic buyer (most common, often at strategic premium)
• Secondary buyout — sold to another PE firm
• IPO — listed on a stock exchange (most prestigious; used when markets receptive)
• Recapitalisation — refinance with new debt + dividend recap to LPs

VC focuses on EARLY-STAGE startups (often pre-revenue) with high growth potential. Sand Hill Road (Sequoia, Andreessen Horowitz, Accel) dominates the US.

Returns within a VC fund follow a POWER LAW distribution: a small number of "outsized winners" (10× or more) account for most of the fund's overall return; most investments fail or break even. Sequoia's Google investment. Andreessen's Facebook. Etc.

Implication: portfolio construction is about having enough shots that a few will be enormous, not about hit rate. Long lock-up (10+ years typical).

AMC (Annual Management Charge): the manager's slice only.

OCF / TER (Ongoing Charges Figure / Total Expense Ratio): AMC + all other ongoing costs (custody, audit, administration, depositary, regulatory) as a % of fund assets. Always higher than AMC.

EU UCITS funds must publish the OCF in the KIID. Excludes transaction costs, which are disclosed separately.

Compare a 1.5% AMC vs a 0.10% index fund fee over a long horizon. Over 30 years at 7% gross growth, the 1.4% differential erodes the final value by roughly 35%.

£100,000 invested at 7% for 30 years:

• At 0.10% fee → ~£700,000
• At 1.50% fee → ~£450,000
• Difference: ~£250,000

Why retail investor education emphasises cost minimisation.

A charge applied to LARGE incoming subscriptions or outgoing redemptions to cover the dealing costs of investing / disinvesting the underlying — passed onto the moving investor rather than diluting existing holders.

KIID (Key Investor Information Document): UCITS short-form disclosure — objective, risk, costs, past performance.

Being replaced by the PRIIPs KID for retail packaged products. Standardised "Summary Risk Indicator" (1–7 scale), cost breakdown, and forward-looking performance scenarios.

• Luxembourg + Ireland: dominate European fund domiciles (€4tn+ each) for UCITS distribution
• Cayman Islands: dominant for hedge funds (tax-neutral, light-touch)
• Delaware: primary US onshore
• UK / Singapore: smaller but growing

UK retail buyers typically access funds via investment platforms / wrap accounts — Hargreaves Lansdown, AJ Bell, Vanguard Investor. Platforms hold funds in a single account, charge a platform fee (0.15–0.45% pa), and allow tax-wrapper choices (ISA, SIPP, GIA) on top.

Important: total cost = fund OCF + platform fee. A cheap fund on an expensive platform can still be pricey.