How Financial Funds Work

MARCH 22, 2016
How Financial Funds Work
Investment funds are one of the main tools for multiplying money around the world. Investing in bank deposits is now unprofitable: in the developed countries, there is a minimum return on them, sometimes even negative, while in developing countries, where the return is higher, there are much greater risks. Endowment insurance is a fairly conservative tool that provides insurance protection and brings a small profit. Pension funds make it possible to gradually accumulate funds for the investor to collect a certain amount of money for retirement.
Investment funds or collective investment institutions (CII) are the ones to make money work. They also provide opportunities for such investments, which would be quite problematic to do on one’s own with small amounts of investments. In addition, the investment fund finances are managed by professional investors, which gives hope for effective investment and, as a result, the high profitability of the investments. Investment funds have a great advantage: they pay income tax only once, after exiting the investment.
When creating an investment fund, its founders attract private investors. In the founding documents of the fund there are indicated requirements to the size of contribution: a minimum or, on the contrary, a maximum contribution amount can be set. Sometimes, however, investment funds are created for a specific pool of investors to finance a specific project. Most often, this approach is used to manage big private capital.
Traditionally, funds can be open, interval and closed ones. In open funds, investors can invest at any stage of its existence, or, for example, if the investor is satisfied with the results of the fund operation in recent years. Exit from such fund is also possible at any time. In the interval funds, it can be done in well-defined periods: once a year, twice a year, once a quarter, once a month (details are specified in the fund’s strategy at the time of its creation). Exit from the closed fund is possible only after its expiry. It is usually three to five years, rarely seven years.
Asset managers either invest attracted funds in various instruments: shares, bonds, bank deposits, precious metals, real estate, or use them to finance business projects. Proportions of investments depend on the fund’s investment strategy. For example, a more risky strategy involves investing in shares, which are high-risk instruments. The share of securities in the portfolios of these funds can reach up to 100%. The risks are great: success depends on the “intuition” of the asset manager. The task of the manager is to determine the risks of certain issuers, to minimize them and to bring profit to investors.
More conservative investors prefer moderate investment policy. In this situation, a part of the funds is invested in fixed income instruments: state, municipal or corporate bonds, bank deposits, precious metals. The higher the proportion of these instruments in the fund’s portfolio, the more conservative its investment policy is considered.
Prospective investors should be reminded: the higher the risk, the higher the potential return. Preferring more risky funds, they are able to earn more. However, the risk of losing a part of investments in such a situation is also higher.
Venture funds represent a separate category of funds. The funds are invested in risky projects, such as start-ups. These funds are suitable for reckless investors: investments can bring a profit of a hundred per cent, or large-scale losses. It has a logical explanation: in the common practice in the world, only one start-up out of 10 is successful.
The fund can invest in new business at various stages of its development. For example, it may be an investment in a viable idea (a “seed” stage). At this point, the idea of the project is developed, its authors are monitoring the market, make a business plan, create a prototype of a product or service. If at this stage authors manage to find an investor, the start-up develops further. If they do not find an investor, the project “dies”. Investments at this stage can be the most profitable, if the business idea turns out to be successful.
It is possible to find such a business idea in the so-called business incubators and accelerators, which provide assistance to start-ups. They help authors of ideas to learn basic business skills, offer training and workshops, provide room to work, help in the preparation of presentations for investors, as well as render a range of non-core services for a start-up on conditions of outsourcing (translators, accountants, lawyers, etc.). In such incubators, all start-ups undergo primary selection: to get into the business incubator, the project must be viable, and its owners must have the desire and the ability to develop it.
It is possible to invest in a start-up at the stage of its launch, when the product or service enters the market, and in the period of growth and expansion. Usually, by this time, the project has demonstrated its viability, and the resource for further development has been exhausted, so its creators have to seek investors.
After the business goes to deep waters, a venture capital fund can fix profits by selling a portion of the business to its owners or to strategic investors. As a rule, life cycle of a venture fund is about 10 years. But there may be open-ended funds, where funds received in the form of profits from projects are invested in new business ideas

Author: Ignas Jurkonis