Investing in Investment Funds: A Beginner’s Guide
At a glance
• Before investing, it is important to look beyond the headlines and assess whether the fund has achieved consistent and healthy long-term growth;
• Sharpe Ratio, Alpha, Beta, Tracking Error, Information Ratio, Treynor, Upside/Downside Capture Ratio, R-Squared, Sortino and Maximum Drawdown are among the most important financial ratios. However, their real strength lies in analysing them together;
• A thorough analysis of financial ratios allows investors to make informed decisions based on facts rather than appearances.
If you’ve been keeping up with the news, you may well have been tempted to invest in investment funds. And it’s no wonder, given that total assets under management have reached an all-time high. Sustainable funds saw a 12% growth, surpassing traditional funds. Precious metal funds performed well in the third quarter, with some gold funds increasing in value by over 50%. These figures are bound to catch the eye of any investor.
However, if selecting investment funds were as straightforward as reading the headlines, everyone would be guaranteed success. The truth of the matter is that things are not as they seem. Even experienced investors can find it challenging to compare and select funds: you need to understand the strategy, analyse the performance history, grasp the level of risk, and familiarise yourself with the management team – all within a landscape full of acronyms and technical jargon.
Any investor should familiarise themselves with the key concepts and clear methodology for making well-informed decisions. This article explains what investment funds are, explores the main types available on the market and presents a practical methodology for comparing, selecting and monitoring funds, and outlines the essential precautions to take before investing.
What are investment funds?
Investment funds are financial instruments that pool the capital of several investors into a common asset, which is then managed by specialist professionals. Rather than selecting, monitoring and adjusting each asset individually, investors delegate this task to a team with access to rigorous analysis, quantitative models, qualitative criteria, structured risk management and global execution capacity.
Investment funds provide access to markets, instruments and strategies that would otherwise be more complex or costly to manage independently. This makes them ideal for those looking to capitalise on their wealth consistently.
The pros and cons of investing in investment funds
Investment funds enable immediate diversification by distributing capital across multiple assets, thereby reducing the impact of individual fluctuations.
In addition, they have professional management supported by rigorous analysis and risk modelling, as well as access to global markets and sophisticated strategies, which would be difficult to replicate individually.
Not to mention the fact that they benefit from regulated structures, operational and fiscal transparency, standardised liquidity, and flexibility. This means that you can select a fund that aligns with your specific objectives, whether that be capital preservation or aggressive growth.
In some cases, liquidity restrictions may limit the ability to redeem immediately. Additionally, performance depends on the competence of the management team; poor decisions could compromise results.
What types of investment funds are there?
To make the right choice, you need to understand the differences between funds and how each one fits into your portfolio.
1. Equity Funds
These investment funds comprise shares in listed companies in specific sectors or different geographical areas. They offer a means of capturing the long-term growth potential of stock markets, but they are always subject to the volatility typical of this asset class. These are ideal for investors who can tolerate short-term market fluctuations and have a long-term outlook.
2. Bond Funds
These funds invest in public and corporate debt. They are often used to stabilise portfolios, as they tend to be less volatile than shares. This asset class has various nuances, such as short- or long-term debt, credit quality levels and inflation-linked bonds.
3. Mixed Funds
As the name suggests, mixed funds combine shares and bonds. Their approach is straightforward: they adjust exposure to risk over time as part of an integrated, balanced solution. They are an interesting option for those who want a more dynamic approach to professional management without having to follow every market movement.
4. Index Funds and ETFs
This type of investment fund tracks the performance of an index, such as the S&P 500 or the MSCI World. Rather than picking individual stocks, the investor buys a "basket” that includes hundreds of companies from these indices.
The main advantage is simplicity: by making a single investment, you are automatically diversified and can track the overall market performance. They provide a practical approach to investing without having to analyse each company individually.
5. Alternative Funds
Alternative funds include private equity, property, infrastructure and other assets less correlated with traditional markets. Although they imply longer time horizons and a detailed analysis of each strategy’s profile, they can add sophistication and risk-adjusted return potential. For high-net-worth investors, they are often an essential part of a diversified portfolio.
6. Thematic Funds
These funds focus on structural trends such as energy transition, digitalisation, artificial intelligence, health, and future mobility. They seek to capitalise on the long-term changes occurring in the global economy and the growth these changes bring. They are of interest to investors looking to add a strategic element to their portfolio that align with their personal beliefs or market trends.
How to invest in investment funds
Investing in investment funds requires clarity of objectives, rigorous selection processes, and disciplined execution and monitoring.
1. Define the objective and the time horizon
Start with quantifiable objectives: "What is the investment time horizon for this capital? What level of risk can I expose myself to in line with this time horizon?”. These goals inform the selection of asset classes and fund types.
2. Determine the fund’s position in your portfolio
Decide how much of your total assets you’re going to allocate to this fund, and consider how this fits into the strategic allocation of your portfolio (shares, bonds, alternatives, liquidity). Follow practical rules such as not investing more than X% in a single manager or strategy.
3. Do your research
Evaluate the manager and their team based on their experience, stability, investment philosophy, risk management processes and compliance. Also analyse the fund’s strategy: asset classes, limits, leverage.
Use a research tool such as the Morningstar Researcher, which allows you to filter investment funds by a series of criteria (such as management company, geographical area, asset class, etc.) to refine your search.
4. Analyse and interpret statistical ratios
1. Market exposure and relation to the index:
These indicators explain dependence, sensitivity and alignment with the benchmark.
Beta
This shows how sensitive the fund is to variations in the market (usually a benchmark index).
• Beta > 1: the fund tends to amplify market movements;
• Beta < 1: the fund is more defensive, moving less;
• Beta = 1: the fund follows the market.
It helps to understand whether the fund is more aggressive or conservative.
R-Squared
This measures the extent to which the behaviour of the fund can be explained by that of its benchmark index. Put simply, it shows how closely the fund is linked to the market or benchmark.
• High R-squared (close to 100%): The fund’s performance closely follows that of the index. The fund’s variations are largely explained by movements in the benchmark market;
• Intermediate R-squared: The fund partially follows the index, but its performance is also influenced by other relevant factors;
• Low R-squared: The fund’s behaviour differs greatly from that of the index. Its performance is more dependent on the manager’s choices and specific strategies than on general market trends.
Tracking Error
This measures the extent to which the fund deviates from its benchmark. Put simply, it shows how different the fund’s performance is from that of the index it is trying to track.
2. Quality of Active Management:
Having clarified the relation to the benchmark, the next step is to assess whether the deviation from the index is justified. The alpha tells you how much value has been created; the information ratio tells you how effectively that value was created.
Alpha
The Alpha measure indicates the difference between an investment fund’s actual and expected returns, based on its benchmark.
• Positive alpha: the fund has outperformed (effective management);
• Negative alpha: the fund has underperformed (less efficient management).
In practice, it measures whether the active management has added value or not, i.e. whether the fund manager has been successful.
Information Ratio
It measures how effectively a fund compensates for the risk it takes on by deviating from its benchmark index. Put simply, it shows whether the manager is consistently outperforming the benchmark. It can be interpreted as the ratio comparing the fund’s excess return with the level of divergence from the index (tracking error).
In practice, a high and positive information ratio indicates that the manager has consistently outperformed the index, thereby justifying the deviations from the benchmark. A negative information ratio means that the fund has deviated from the index without creating value; the additional risk has not been offset.
3. Return adjusted to Risk:
This section should contain ratios relating return to risk from different perspectives:
• Sharpe ratio: the return per unit of total risk;
• Sortino ratio: the return per unit of negative risk (falls);
• Treynor ratio: the return per unit of market risk (beta).
Sharpe Ratio
• It measures the excess return per unit of risk.
• It is calculated by comparing the return on the fund with that of a risk-free asset (e.g. public debt).
• High Sharpe: the fund generates a good return relative to the risk assumed.
• Low or negative Sharpe: the fund does not adequately offset the risk.
• This ratio is crucial for comparing investment funds that carry different levels of risk. For instance, two funds may achieve the same return, but one of them may have been much more volatile in the process. Which is preferable? The one with the lowest volatility.
Sortino Ratio
It measures the return generated by a fund, taking into account only the risk of loss. Put simply, it shows how well the fund rewards investors for periods when they risked losing money. Unlike other ratios, the Sortino ratio ignores positive volatility (upswings) and focuses solely on negative ones.
• High ratio: the fund has achieved good returns with minimal or minor falls. This indicates efficient downside risk management.
• Low ratio: the fund’s returns were significantly lower than expected.
• Negative ratio: The fund either made losses or failed to compensate for downside risk.
Treynor Ratio
This ratio indicates the return generated by a fund for each unit of market risk assumed. This ratio compares the fund’s excess return (i.e. the return above that of a risk-free asset, such as deposits or short-term government debt) with market risk, as measured by beta. A higher Treynor ratio indicates a stronger relation between return and market risk.
4. Behaviour in Market Cycles:
These indicators reflect investors’ practical experience in light of market developments.
• Upside capture – gaining from upswings;
• Downside capture – downside protection.
5.Risk of Accumulated Losses:
Lastly, the most intuitive and emotional indicator:
Maximum Drawdown
• It represents the largest fall recorded by the fund from a peak to a subsequent low in a given period;
• It shows the worst possible historical scenario and helps to assess the risk of significant losses.
In summary:
These indicators allow us to evaluate a fund based not only on its profitability, but also on the quality of its management, the risks it takes, how it behaves and how consistent it is with the market. It is essential to interpret them in order to make more informed decisions that suit your investor profile.
Analyse Costs:
Some funds charge fees for subscriptions, redemptions or performance, among others. It’s important to check these costs before investing. It is important to analyse the TER (Total Expense Ratio) because it provides a quick and simple overview of all the fund’s commissions and annual costs.
5. Read the mandatory documents closely
Read the Key Information Document (KIID), the prospectus, and the annual and half-yearly reports. These documents set out the investment policy, main risks, fees, liquidity rules and conflicts of interest. Look out for terms such as "limited liquidity”, "lock-up”, "performance fee” or "hurdle rate”:
• Limited liquidity: This means that you cannot withdraw your money from the fund at any time. You may only be able to redeem the investment on a few specific dates per year, or there may be a minimum holding period before you can withdraw the money;
• Lock-up: This is a mandatory period during which investors cannot redeem their money. It is similar to a "closed period” and is usually employed for strategies that require long-term stability;
• Performance fee: This is an additional fee charged by some funds if they achieve certain results. In addition to the normal management fee, an additional fee is applied when the fund performs particularly well;
• Hurdle rate: This is the minimum level of return that the fund must achieve before it can charge a performance fee. For example, if the hurdle rate is set at 5%, the fund will only charge extra commission on earnings above this value.
Compare the total cost, taking into account the management fee, performance fees, subscription/redemption fees, transaction costs, and any custody fees.
6. Test the fund in a "pilot” and simulate scenarios
Consider starting with a pilot position to test how the fund behaves in real conditions. Simulate results in stress situations (market drop of 20 to 30%, rate hikes, liquidity crisis).
Use the fund’s historical data (or that of comparable strategies) to calculate the expected drawdown – the maximum possible drop in value that the fund could experience in a given scenario or timeframe. Additionally, you can estimate the recovery time: the amount of time it usually takes for the fund to return to its pre-downturn value.
7. Confirm the legal structure and safeguarding of assets
Make sure that the fund vehicle is supervised by a competent authority (CMVM or equivalent), that the assets are segregated and that there is an independent depositary.
8. Pay close attention to the operational aspects of the purchase
When executing the order, validate both the ISIN (the international securities identification number) and the legal vehicle. Keep the supporting documents, such as the contract, order confirmation and updated prospectus, and make a note of the subscription/redemption cut-off dates and applicable NAV.
9. Monitor and re-evaluate
Set up a review schedule (e.g. quarterly for active funds and biannually for alternatives) and define control indicators.
Alternatives to investment funds
Although investment funds are an efficient way to diversify and delegate management, there are other solutions that can complement (or, in some cases, replace) this type of product.
1. Unit-Linked portfolio management
The Unit-Linked combine life insurance with investment funds managed by specialists. These funds offer investors access to a range of risk profiles, from conservative to dynamic, depending on their financial objectives and risk tolerance.
Advantages: A flexible and personalised solution combining continuous professional investment management, the potential for financial appreciation and adaptation over time, and a life insurance component. Depending on the applicable framework, it can also offer tax benefits.
2. Structured products
The structured products are financial instruments designed to offer a combination of features, such as capital protection, participation in market growth, regular income, or exposure to specific themes.
Advantages: The ability to define the exact type of return desired with defined limits, buffers and scenarios.
3. Bonds and debt instruments
For those seeking stability, predictability of cash flows and control over credit risk, buying sovereign or corporate bonds directly can be an efficient alternative.
Advantages: Good visibility of maturities, coupons and risk.
4. Private Equity and Private Debt
Direct access to private operations and the financing of unlisted companies or specific projects. These alternatives seek to deliver returns that differ from those of traditional markets and require a longer-term outlook.
Advantages: Greater potential for appreciation and exclusive opportunities available outside of the public market.
5. Real estate through specialised funds and companies
Investing in real estate through specialised funds or companies, such as property investment trusts or REITs, can provide a buffer against volatility and generate relatively stable income without the need for direct asset management.
Advantages: Exposure to real assets through a diversified and regulated portfolio, offering the potential for recurring income and gradual appreciation over time.
Investing in investment funds at Banco Carregosa
Investing in investment funds requires a methodical approach and specialised monitoring. When chosen carefully, a fund can be an important part of a well-balanced and consistent portfolio.
At Banco Carregosa, this approach is ingrained in our DNA. We support each client in making financial decisions by offering rigorous analysis, access to a range of solutions, and a team that understands the complexities of substantial asset management.
Are you looking to build or enhance your investment portfolio with investment funds (or explore strategies to optimise it)? We’re here to support you every step of the way. Talk to us to find out how we can help you build a portfolio tailored to your assets.