How investment funds work

One of the first questions that investors ask themselves is where to invest their savings. Investment funds are one option.  

An investment fund is a Collective Investment Institution (CII). This is a savings instrument that gathers together contributions made by a number of people (shareholders) who want to invest their savings. All of these individual contributions are invested in financial instruments (stock, fixed-income securities, derivatives or a combination of these).

The fund shareholders have access to markets which, in many cases, would not be available to them if they had invested individually. This helps them to diversify their investments more easily and efficiently. Shareholders therefore trust their savings to a professional (fund manager) who deals with analyzing the market with a view to finding opportunities to general returns on the shareholders' contributions.

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The shareholder, in exchange for the professional investment management, has to pay some fees, are explained in the information booklet for the fund, within the terms established by law. These include a management and deposit fee which is charged directly to the fund (value is deducted from the fund assets, reducing investor returns). For some funds, the fund manager may charge the shareholder subscription and/ or share redemption fees directly.

Key players in investment funds

Shareholder: the person who invests in the investment fund.

Management Company: the entity that invests the capital contributed by the shareholders in the various financial assets that make up the fund portfolio (fixed-income, equities, derivatives, bank deposits, etc.). The management company for the fund is responsible for drafting the booklet that gathers all the fund characteristics.

Depositary Institution: This is the institution that holds the fund assets and assumes control of the management activity, for the benefit of the shareholders.

But how does an investment fund really work?

The operation itself is quite simple. The investor selects an investment fund and buys shares in it. But at what price? This price is what is known as the net asset value of the fund. It is simply the result of dividing the assets of the fund by the number of shareholders involved at that time.

Any investor can buy and sell shares, at any time. Purchasing shares is known as 'subscription'; and selling shares as 'redemption'. Therefore, as investors buy and sell shares, the fund assets increase and decrease. Additionally, fluctuations in the market value of the fund investment assets can give positive or negative results, which increase or decrease the capital and therefore the net asset value of the fund also experiences these fluctuations.

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Taxation of investment funds

One of the major advantages of investment funds is their taxation. Shareholders in an investment fund will only pay tax when they redeem shares. At this time, yield is generated which, for tax purposes can be considered capital gains or losses and must be incorporated into the tax assessment base for savings in relation to Personal Income Tax.

Also, transfers between funds is exempt of tax. This means that if you redeem (sell) the shares of a fund and you reinvest (buy) in shares in another fund, the potential capital gains are not subject to tax. There are two expenses that can be deduceted: the expenses associated with subscribing and redeeming the shares. Remember that you can see more details about taxation of investment funds here.

In short, investment funds are very attractive instruments for individual investors because they provide access to markets which, at other times, would not be possible, thus facilitating better financial planning thanks to the tax advantages available.

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Investment fund tools

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