Mutual funds

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Note: this page deals principally with mutual funds as known in France , but most of the principles explained can apply to all European professionally managed collective investments. At least, it may provide useful information to anybody who needs to know how mutual funds are managed in France .

Definition

Mutual funds (known in France as OPCVM, Organismes de Placement Collectif en Valeurs Mobilières = often referred to as UCITS or mutual funds) are companies or quasi-companies whose purpose is to invest the capital subscribed by investment unit holders in financial markets. A mutual fund is thus a manager of collective investment funds, as distinguished from:

  • proprietary asset management: the mutual fund invests money collected from third parties (third-party asset managers) and not its own money (proprietary asset management).
  • management under mandate: the mutual fund invests the collective funds belonging to a number of third parties and not a single third party (private wealth management).

The liability side of a fund's balance sheet includes capital provided by subscriptions of unit holders.

On the asset side, a mutual fund includes the financial instruments it holds.

Liabilities

Mutual funds' liabilities are broken down into units held by subscribers who are thus the fund's shareholders. Each time an investor subscribes to the fund, the latter issues, in exchange for the subscription amount, new units of which the investor becomes owner. A mutual fund share constitutes a transferable security identified by an ISIN code whose issuer is the mutual fund's management company and whose price is the net asset value.

Assets

Funds use fund-holder money to invest on markets. The fund's assets include all securities held (e.g. equities, bonds, negotiable debt instruments, derivatives, etc.). The fund manager does not have total freedom to invest as he pleases: he operates within the framework laid out by market regulations and the management guidelines defined at the fund's creation.

Net Asset Value

The fund's assets value vary continuously depending on changes in the prices of the financial instruments held. The total of assets held based on the day's prices, divided by the number of units issued, equals the fund's unit NAV (Net Asset Value) or unit value.

As such, the liability side of the fund's balance sheet equals the number of units issued times the value of each unit, the unit NAV. There are two main reasons why the value of the fund's liabilities changes constantly. First, the number of units issued changes depending on unit subscriptions and redemptions. Second, the value of units is continuously changing. One well-know French fund variant is the SICAV (Société d'Investissement à Capital Variable = open-end investment company with variable capital).

How it works

The fund "lives" in the following manner:

Equity is built up by subscription from final investors who receive unit shares in exchange for the funds they bring. One or more units are created with each new subscription.

At the same time, the investor may redeem the amount invested plus or minus any increase/decrease in the fund's NAV since his investment. Each buyback has the effect of destroying one or more fund units. Subscriptions/redemptions are made at the liquidation price on the day the order is executed.

Certain funds are listed every day, i.e. net asset value is calculated daily. Others are listed just once a week or even once a month.

A fund may have a “known” price, i.e. the NAV on day D is calculated on Day D. Such is the case with equity funds. Subscription/redemption orders may be executed the same day they are received in this case. But a fund may also have an “unknown” price. In such a case, the NAV is known on D+1 or even "very unknown," becoming known only on D+2. The execution of subscription/redemption orders for these funds is held off until the next day or the day after the next day following reception of the order.

The fund's asset value depends on the investment decisions made by the investment management company and its portfolio manager. It operates on regulated markets via investment management companies or via brokers on over-the-counter markets. The execution and settlement/delivery of transactions fall under the responsibility of the fund's custodian bank.

French funds categories

Collective investment management operates under the principles set by a European directive defining UCITS (Undertaking for Collective Investment Schemes in Transferable Securities). Not all funds issued conform to this regulatory framework, which is not adapted to the new asset management trends (e.g. hedge funds).

Mutual funds can be classified according to their legal structure:

  • SICAVs (Société d'Investissement à Capital Variable = investment company with variable capital) have legal personality.
  • FCPs (Fonds Commun de Placement = open-ended collective investment funds) without legal personality unlike SICAVs and with lower minimum capitalisations.
  • FCPE (Fonds Commun de Placement d'Entreprise = company employee savings plan) are used exclusively for employee savings.
  • FCPRs (Fonds Commun de Placement à Risques = French Venture Capital Fund) and FCPI (Fonds Commun de Placement dans L'innovation = tax-incentive high-tech venture capital funds) are partially invested in unlisted companies

Mutual funds can also be classified according to their investment focus which also defines their risk profile:

  • Shares, which may be specialised by regional area, size of companies, sector,
  • Money market: invested in negotiated instruments and deposits (debt instruments)
  • Bonds.
  • Diversified instruments.
  • Formula funds: the management target backed up by a guarantee, generally speaking, on the capital invested.
  • Fund of funds (multi-management): these funds invest in other funds' units.

Mutual funds can be differentiated according to management style:

  • Active management for the manager consists of choosing in a discretionary way from a large selection of securities that meet the requirements of the fund's profile. The manager may make use of derivative products to hedge against portfolio risk.
  • Passive or index management consists of mimicking a benchmark index. This style was created in recognition that over a long period, active managers do not outperform the market.
  • Exchange-traded funds (ETFs) are funds index-trackers listed on the stock market and therefore negotiable, unlike usual funds.
  • Alternative or hedge funds apply a very targeted strategy with an absolute performance goal.

Role of the various players

Given the numerous investment management players, it is often hard to figure out who does what. First, it is important to note that (at least in France ) third-party asset management must be organisationally separated from proprietary investment management, in accordance with market regulations. That is why major banks and insurance companies all have separate asset management subsidiaries, often with the AM (Asset Management) added to the company name.

Asset management is increasingly developing from an internal banking service into a specialised outsourced activity. The increasing sophistication of computer systems and technology has made fast trading and order processing a key strategic factor in what has become a real industry.

Marketing

Banks have traditionally relied on their branch office network to market their funds (attracting new subscribers). There are also entities that specialise in the marketing funds: these are calles funds distributors.

Liability management

Liability management consists of centralising subscription/redemption orders and keeping the mutual funds accounts.

The transfer agent is the intermediary responsible for centralising subscription/redemption orders and proceeding to exchange funds for subscribed fund units. This exchange, which is a settlement/delivery operation, can be made directly with the fund issuer but many use Euroclear France in France (the French central securities depository).

Custodial management consists of constantly updating the number of funds units issued which, as we noted earlier, changes continuously.

The registrar job in English-speaking countries, where its role is much larger, is referred to as transfer agent. The transfer agent sets up a support structure for distributors. It really acts as the interface between funds and distributors, collecting and executing subscription/redemption orders, keeping positions of external distributors, calculating and recording fees due to them and producing reports to business finders.

Asset management

The fund manager's goal is to make investment decision and take market positions with a view to generating a return on assets under his management. This is a front-office function.

He is aided in this process by financial analysts whose role is to collect information on and relating to listed companies in order to make investment recommendations to investment managers.

Administrative management and accounting

The administrator and accountant manages the fund's trading desk and back offices. It records transactions, forwards settlement/delivery instructions to the depository agent, keeps track of positions and monitors risk.

The account manager is also responsible for calculating the fund's NAV except in those cases where the task is outsourced to a specialist service.

Depository bank

In France the function of the depository service is governed by the AMF (Autorité des Marchés Financiers) which defines its role and obligations in a detailed specifications file. The reader can consult the fund depository services' purpose and functions at the following Web page: Depositaries of UCITS and AIFs

The depository bank creates a precise file on the fund including documents approved by the AMF during the fund's creation (authorisation, information note).

The depository bank ensures the settlement/delivery and custody of fund assets. It maintains custody of fund assets, keeps up-to-date security and cash accounts, receives settlement/delivery orders and executes them in conjunction with the central security depository or local foreign sub custodians and informs the fund of securities transactions or other events on its portfolios and processes them.

The depository bank monitors the regularity of the fund's investment decisions (See Function of depository monitoring or trustee, below).

Moreover, the depository bank may take responsibility for the fund's liability management, although not always.

Depository monitoring or Trustee

The depository's monitoring consists of verifying the regularity of the fund's investment decisions and the calculation of NAV. The mutual funds activity being strictly defined in France and the rest of Europe, trustees play an important role and include many tasks.

Verification includes ensuring compliance with market regulations with respect to asset breakdown and risk distribution (particularly issuer risk).

Verification of the fund's situation means verifying that its investments are in compliance with its management goals as described in its information note.

The depository monitor also verifies the fund's calculation of NAV.

He verifies the documents produced by the investment management company: annual reports, financial statements, periodic reports.

Fund accountant

The calculation of NAV is a complex process because it involves finding/determining a price or calculating a value for each fund asset. These can be numerous, and they may include exotic products or unlisted securities in the case of OTC instruments.

The fund accountant uses calculation tools to propose numerous value-added services to the fund, including reporting, analysis and performance attribution.