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Investment funds – Basic Concept

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1. What is it?

The main idea behind an investment fund is the same that can be found in an association. In an investment fund a group of people comes together to jointly invest their resources, using a series of different options made available by the financial market. Normal persons as well as companies may invest with funds, according to a number of objectives. Funds, on their own, may also choose from a variety of assets an investment options, according to their specific objectives. This session is dedicated to explaining basic rules that apply to all funds as well as distinguishing them based on specific categories they fit.

In an investment fund there isn’t a minimum or maximum number of quota holders: they could have anything from one quota holder to hundreds. The bylaws of each fund will determine the rules for entering and exit of quota holders, minimum investment terms and rules for stock trading; as well as any administrative and performance fees. The set of bylaws will also determine if this particular fund has a due date for extinction or not.

The Brazilian SEC (or CVM, in Portuguese), has a ruling that regulates all investment funds: the CVM instruction number 409.

All funds have to follow the determinations enclosed. Along with other details, it states that the only assets that could possibly be included in an investment funds portfolio are those that can be traded in the stock exchange, the futures and commodities exchange or those registered with a regulated registry, custody or financial liquidation system duly acknowledged by the Brazilian Central Bank or the CVM.

Investment funds have varying characteristics and particularities, from the minimum investment level to investment terms, to the specific type of asset. Before choosing this type of investment one should always read the fund’s bylaws and regulations, to make sure they’re in line with the investor’s intentions.


2. Main investment fund types

  • Fixed income funds
  • Variable income funds
  • Multimarket or Multi-asset funds
  • Real estate funds
  • Receivables investment funds (FIDC, in Portuguese)
  • Exchange traded funds – ETF (Index funds)
  • Foreign exchange funds
  • Foreign debt funds
  • Investment funds in others investimento funds
  • Off-shore funds

3. Characteristics

Opened funds

With opened funds quota holders may enter or exit at any time. This means that new investors can enter, old investors can increase their number of quotas and redemption can be requested by any investor at any time. To match those entry and exit movements, the fund administrator will acquire or liquidate assets, thus guaranteeing new investments or payment on required redemptions. Therefore, open funds have a varying number of quotas – and quota holders. They also have, on account of this flexibility, a greater liquidity.

Usually, opened funds have an undetermined duration period and no limit on the number of quota holders. Administration and performance fees should be provisioned per work day, always as a fund expense and payable as described in the fund’s bylaws. Not only that: the fund has to publish, daily, the quota value and the fund’s net assets.

If an open fund keeps a daily net asset average of anything below R$ 300 thousand for 90 consecutive days or more, it should be liquidated or incorporated into another fund.

Closed funds

With closed funds a limited number of quota holders is set in the fund’s bylaws, and both entry of new holders and exit of existing ones is forbidden. Only during the quota holder’s general meeting can the distribution of new quotas be considered.

Closed funds have a duration period preset, and only then any quota holders will be able to exit the fund. This rule can be bent if the fund is liquidated before that date, of if determined by a general meeting. Early redemptions may also be allowed by general meetings – or foreseen in the bylaws.

It’s also possible to sell quotas of a closed fund to another investor. This can only be done with funds being traded in the stock exchange or on the OTC market. If foreseen in the bylaws, transference of ownership may also be a possibility, provided it be done in writing and signed by both parties.

Restricted / Exclusive funds

The restricted investment funds have received investments from a specific cohort of quota holders, usually companies inside the same economic group, members of a same family or such. This restricted group has the same investment objectives, necessarily. In many occasions, restricted funds are also exclusive.

Exclusive investment funds receive investments of a single quota holder. And this investor will, necessarily, be rated a qualified investor. The advantage of na exclusive fund is the personalized management, focused on satisfying the demands of a single investor. Is this investor is not happy, they may require the fund be transferred to another institution without exiting the fund – and consequently avoiding unnecessary taxation.

For exclusive investment funds, launching prospects and marking-to-market are optional.

Qualified Investors

Qualified investors may be:

  • Financial institutions;
  • Insurance companies and special savings companies;
  • Public and private social welfare entities;
  • Portfolio administrators and securities consultants authorized by the CVM, relating to their own resources
  • Social security and pension funds created by the Union of States of Brazil, by the States, by the Federal District, or by Municipalities
  • Investment funds destined exclusively to qualified investors
  • Normal persons or companies that own investments amounting to R$ 300 thousand or more. These
    investors should attest their qualified status in writing.

Investment fund grace periods

Investment funds may establish a grace period for the redemption of the investment, with or without profits. The main difference between funds that establish a great period and those who wave it is the potential liquidity. Receivables investment funds usually establish a grace period. The investor should always consider
this type of rule when choosing an option – only look for funds with grace periods if the money invested will not be needed in the shorter term.

Mark-to-Market

Investment funds have to adopt a mark-to-market policy when registering the assets in their portfolio. Marking-to-market is no more than making quota values reflect the actual market prices of the assets in the portfolio. Should that be a difficult price to pin point, a respectable forecast has to be made, considering a potential trade in the future.

At the end of each day, the prices should be observed after the markets closed. In the case of variable income assets, the average price of the shares shall be observed during the day and computed in marking the fund market. In the case of fixed income, market-to market should also be made. Pre-fixed bonds also suffer price swings until your due date, and therefore the price of the security in the Fund shall be computed in a way that reflects the actual price of the bond, ie, through a judicious preview of future trends in interest rates and market expectations of market reaction to these trends.

For example, if you bought a bond and immediately after the interest rate falls, the price of your bond will increase, generating a gain for you, because if you sell, the price now is higher than the price that you paid. The opposite is also true. If you buy a bond, and shortly after the interest rate rise, the price will fall (however, if you take your bond to maturity, he will earn the interest rate agreed at the time of purchase). It is this variation in the price of bonds that should be reflected in investment funds.

The main goal of marking-to-market is avoiding the transfer of wealth between quota holders, as well as giving a greater transparency when it comes to risk assessment for price fluctuations on the assets. Real prices have to be reflected on the quotas, making it easier to compare fund performances.

Rating

Some funds require an evaluation as to their risk level. This evaluation is called rating and is conducted by specialized companies that take into account all risks that might have an impact the return on the investment. This means considering the country of investment (economy, finances, politics and such), the binds, financial institutions, among others. Rating will help investors and institutions choose which funds to invest in, as for their solidity and risk.

Active and passive funds

Active Investment Funds – or funds with an active management – reach for the best possible performance. In other words, aim to overcome the benchmark. Therefore, an active management tries to find the best investment opportunities and has, as a main goal, maximizing results. This makes for an aggressive profile, a higher operational cost and a better short term adjustment.

Passive Funds – or funds with a passive management – focus on following or replicating a specific benchmark. As a practical example, a fund seeking 100% CDI profitability (CDI being the benchmark here) will focus exclusively on reaching that mark. When choosing a passive fund, one cannot expect massive earnings, or profits that differ much from the benchmark of choice. This makes for a more conservative profile, with lower operational costs and better long term adjustment.

Leveraged funds

Leveraged funds usually use derivatives to widen their market exposure. This means greater opportunities for profits – or losses (including the entire fund resources and sometimes even more). Usually, this is a common strategy for aggressive funds. To know if this is the type of fund chosen, one needs to only read the prospect in detail and verify if the regulations allow for this kind of action. It’s important to note that some funds use derivatives only for hedging, and not as a means of pushing the fund into a specific direction. The biggest problem with leveraged funds is risk: a higher volatility can sometimes mean losing all the money invested. In many occasions, a new investment will be required of the quota holder, to close the whole caused by previous losses.

Short term funds

Short term funds should allow for the least possible volatility. They should destine resources exclusively to public federal bonds, prefixed private bonds or bonds indexes by Selic (the Brazilian prime rate) or other such interest or price rate. The maximum due date for this type of fund should be 375 days, with an average due date of no more than 60 days. Derivatives are allowed here, but exclusively for hedging.

Performance fees are prohibited for this type of fund, except for qualified investors.

Index-pegged funds

Index-pegged funds are those whose performance follows a certain reference – usually a currency, index, rate or indicator, among others. The main idea behind this type of fund is leaving absolutely no doubt to the investor as to investment policies and references, once the name of the fund is read.

As a practical example, if a fund is pegged to the DI rates (or CDI, in Portuguese) it’ll focus most of its resources into DI indexed assets, trying to follow the variations of this particular indicator.

Conditions that make a fund into an index-pegged fund are:

  • Having at least 80% of its net assets be National Treasury or Central Bank bonds (Brazilian), be it in a cumulative or isolated manner, or have them be fixed income assets considered to be low in risk by the administrator and manager;
  • Having a minimum of 95% of its portfolio made of assets that follow directly or indirectly the indicator of choice;
  • Restrict its performance on the derivative markets to operations that will protect positions held in kind, until their limits.

The performance indicator of choice should be explicitly specified in the fund’s name. Charging performance fees is not allowed, except for qualified investors.


4. How it works

Investment funds should follow a set of rules put forth by the CVM (the Brazilian SEC) and by the Stock Exchange. Besides, an investment fund has specific characteristics, such as quotas and administration fees, and administrator and a manager. The main characteristics of an investment fund are detailed below.

Administrator

The administrator is legally responsible for the workings of the fund. He will defend quota holders’ interests and communicate with them. The administrator will necessarily have to be a broker, brokerage house, investment bank or multiple asset bank. The chosen administrator will care for all documents and legal registrations of the fund, as well as looking over the success of its inner workings.

Among an administrator’s obligations are: the registration of each quota holder, the official letters calling for general meetings, financial demonstration sheets and, most of all, preserving the best interest of the investors by not allowing transactions that might endanger the fund’s assets; among others.

Custodian

The Custodian is responsible for guarding the fund’s assets. He will forward data and information to the administrators and managers, as well as being the one responsible for marking-to-market all assets in the fund’s portfolio. Usually this is done by CBLC – Companhia Brasileira de Liquidação e Custódia (or Brazilian Company for Custody and Liquidation, in lose transaltion). So, if the administrator bankrupts itself, all funds under CBLC’s custody will remain safe.

Manager

The manager of a fund is an institution responsible for buying and selling its assets to guarantee the best possible profitability, always in accordance with the funds rules, policies and goals. The manager may be a bank or an independent company, or even a real person, as long as they hold a CVM registration. He will be responsible for choosing which assets to invest in, which percentages to buy or sell and the right time to exit a specific investment.

Should the fund get “out of frame” – meaning have its portfolio differentirely from what’s set by the funds internal regulations – the manager will have to make the required changes to make sure the rules are followed as closely as can be, in the shorter time possible.

Quota holder

A quota holder is an investor placing his resources in the fund. To do so, they have to buy a certain amount of quotas from the club or investment fund of their choosing: remembering money will be paid not only for the quotas, but for administrative fees and other such charges that will ensure the administrator has money to coordinate the fund and manage the resources in the financial market.

When buying quotas in a fund, the investor agrees to be subject to the funds regulations, including minimum investment levels, times and dates for investment and exit, shared expenses and such. They will also have the same rights as the other holders, regardless of how many quotas were acquired.

Each and all quota holders should be made aware of the fund’s goals – meaning its investment policies, administration and performance fees (if existing), pre-requisites for exit (if existing), as well as receiving monthly balance sheets of investment detailing: quota value, net asset value for the fund, typesetting and profitability of the portfolio and income tax demonstrations.

The quota holder should sign a Compliance Term, stating they’ve received the prospectus and fund’s regulations, and are aware of the fund’s investment policies – as well as of all risks involved.

No quota holder can detain more than 40% of a fund.

Independent auditor

All funds should have an independent auditor to check all the fund’s accounts at least once every year. The independent auditor’s work consists of checking if the fund has complied to its regulations, as well as any rules and regulations of the market. Checking the fund’s results is also among their obligations.

Quotas

Quotas are a share of the net assets of an investment fund. They are indivisible, registered and recorded in book-entries, and cannot be transferred or desisted, except by court order.

When an investor puts resources into a specific fund they’re buying quotas in this fund. The values of these quotas (and therefore their purchase cost) are calculated daily because the fund’s assets incur in a daily profit according to the investments made by this fund in the financial market. Values change, but an investor will always hold the same amount of quotas, except:

  • If the investor redeems all or part of their investment, therefore reducing their number of quotas;
  • If the investor puts more money into the fund, thus increasing their number of quotas;
  • Income tax withholding was done by the fund (which occurs in the last day of both May and November of each year). The income tax owed by each investor is deduced from their quotas in a process known as “quota-eating”, thus reducing the overall number of quotas they own;

To calculate the value of a quota the investor needs only to divide the total net assets of the fund by the total number of quotas existing. By multiplying the value per quota by the number of quotas, the investor will know how much money they have invested in the fund, before tax.

Quota-eating

The quota-eating is nothing more than a kind of binding advance income tax. Your deduction always happens on the last day of May and November, ie, two times per year. This collection of tax in advance is so named because it decreases the total amount of quotas, ie, the amount that you own is always decreased when the come-quotas occurs.

There is no incidence of come-quotas in equity funds, and the payment of Income Tax always rescuing the application, the rate of 15%.

Funds for Long-Term Investments, the rate of come-quota is 15%. For Short-Term Funds, the rate is 20%.

The Income Tax is calculated daily and accrued on your account. Every six months (May and November), the lower rates of regressive IR table of each type of fund, the quotaholder on income are applied. So if your application reaches the minimum tax rate, this provision ceases to exist. Remember that there is no double taxation in come-quotas. For example, if your application stay invested long enough to reach the lower rate of income tax, no IR in the rescue, the event has already occurred quotas-eating. Otherwise, if you redeem before reaching the lower rate of IR, at the time of redemption, you will pay only the difference.

Administrative fees

The charged administrative fee aims to serve as payment for the services rendered by the administrator. The value usually accounts for expenses with management, investment consulting, treasury, control and processing of assets, registering all quota movements in the books, among other things. This fee is detailed in the fund’s bylaws, and is usually charged based on a percentage of the total annual net assets of the fund (252 business days). This fee is also calculated daily, so all statements already account for this amount being withheld from the total informed.

Because of its nature, the administrative fee will directly impact the profitability of a fund – and that should always be taken into account when choosing a place to invest. Fees that surpass an average of 1% a.a. will already have a very serious impact on the bottom line.

Performance fees

Performance fees aim to serve as payment for the ability displayed by the administrator or the manager in surpassing the profitability anticipated by the fund’s reference indicator. As a practical example, in a fund is referenced at 104% of the DI rate and the manager or administrator manages to present higher profits, they may charge a fee for surpassing the initial mark. Performance fees are not, however, charged by all funds – nor are they mandatory.

Performance fees may only be charged once all other expenses have been provisioned for. They’re usually charged every six months and are also calculated and withheld daily.

Expenses and duties

Asides from administrative and performance fees, other expense and duties are due by investment funds. Among them:

  • Expenses pertaining from notary public charges, printing, expediting and publishing reports
  • Taxes and duties over assets and other such properties of the fund – like payroll taxes, for instance.
  • Mailing expenses
  • Independent auditing expenses
  • Possible legal fees and charges
  • Custody and liquidation expenses
  • Bank fees
  • Stock exchange and CVM (the Brazilian SEC) charges

Entry and exit fees

Although not yet common in Brazil, local legislation does allow for the charging of entry and exit fees. This type of recourse is very common in the US market and aims to making investors keep their money in the fund for the longest possible time. Longer investment commitments allow for trading in longer term bonds and, therefore, for a higher possible profit.

Bylaws

The bylaws of an investment fund are a document where all rules and operational principles of this investment club or fund are stated. Here the rules and regulations to which the administrator and manager are subject will be detailed, as well as investment policies, minimum investment requirements, general meetings and such. Basic details available in one such document are:

  • Appointment of an administrator, manager and custodian
  • Duration period: determined or undetermined
  • Investment policies (main portfolio directives, possible derivative trading restraints and such)
  • Administrative and performance fess (if existing)
  • All duties and operational costs
  • Management regulations and mandates
  • Rules for calling and conducting general meetings
  • Etc.

The bylaws may be altered by general meetings. All changes will be effective after 30 days, except if otherwise provisioned by the totality of quota holders.

Registration

All funds need to be registered with the CVM (the Brazilian SEC). Registration can be done via website by the administrator: more details are available at the CVM’s official webpage.

General meetings

The general meeting of shareholders is a meeting to discuss on certain matters relating to the fund, such as:

  • Financial reports
  • Replacement of the administrator or the manager (if the latter was initially elected by a general meeting)
  • Merger, incorporation, break, transformation, dissolution or liquidation of the fund
  • Rise in administrative fees
  • Change in the fund’s investment policies
  • Change in the bylaws

General meetings are called annually, within 120 of the end of the current mandate. It may be held via videoconference, conference call or via internet. The meeting may be called by the administrator, by a request made by the manager or by quota holders’ requests – provided the group requiring the meeting represents no less than 30% of the holders or of the total amount of quotas issued.

Further regulations are provided by the CVM’s 409/2004 instruction.


5. Differences between investment clubs and investment funds

The main point of difference between an investment fund and a club is on the way the assets are managed. On clubs, management can be left to the participants, if they so choose. On funds, quota holder cannot, under any circumstances, manage or choose the assets that will compose the portfolio.

Another basic difference is that, in a club, the maximum number of participants cannot exceed 50. For funds, the number is unlimited. Costs and legal documents needed to start a fund are also higher and more complex.

Both, however, are subject to CVM and Stock exchange rules and regulations, and have similar operational premises.


6. Profitability

Profitability of investment funds varies greatly, and is usually profoundly linked to the fund’s specific strategy, assets of choice and general economic factors. Since the manager is responsible for choosing assets, a highly trained professional may maximize profitability – although there are no guarantees they will. It is very difficult to predict future profitability of a fund, not only because of the assets of variable income, but also because good past numbers cannot foresee similar results into the future.


7. Risks

Market risk is a factor when dealing with investment funds. This means all investments made in this fashion are subject to market fluctuation. Examples of market risks: Operations subject to foreign exchange, interest rate, equity prices, commodity prices (commodities), among others.

When choosing an investment fund, one should always account for the possibility of losing money, or even having to cover further losses of the fund – however rarely. The strategy is key for this type of trade. Risk levels for fixed income funds, for instance, will necessarily be smaller than for stock Exchange funds.

Know of the existence of risks when investing money is crucial in choosing the final destination of your money because if you do not accept that money can devalue, even for the short term, it may invest in investment funds is not for you.

Some standards of measurement may help the investor when choosing what fund to invest in. The fund’s volatility will indicate whether the assets in the portfolio tend to have too many price variations. Higher volatility indicates higher risk assets, and may not be the best choice.

The fund’s rating should also be checked before opting for it. Specialized agencies rate funds by attributing them a score and publishing the results. Scores are given based on solidity and the ability to provide clients with high quality services.


8. Taxation

Based on the typesetting of the fund’s portfolio, taxation occurs in two basic forms:

1. If more than 67% of the portfolio is made up of stocks, issuing certificates, depository receipts, Brazilian Depository Receipts (BDR), stakes in stock funds and stakes in stock index funds, the income tax rate will be 15%.

2. If the assets detailed above make up less than 67% of the fund’s portfolio, income tax rates follow the table below:

  • Investments for up to 180 days: 22.5% (only over profits)
  • Investments between 181 and 360 days: 20% (only over profits)
  • Investments between 361 and 720 days: 17.5% (only over profits)
  • Investments over 720 days: 15% (only over profits)

Income tax will be calculated based on the positive difference between the value of the quota when acquired and the value of the quota at the time of redemption. This means charges will only be made if there is a real profit. Any losses made on redemption made be compensated on future redemptions (if they show a profit) of the same fund. Loss compensations can also be made via redemptions on other funds of the same nature, provided all funds are administrated by the same company.

Income tax payment is the responsibility of the fund’s administrator, and it must be withheld at the time of redemption and paid on the 3rd work day of the week following the redemption date. Quota-eating schemes may also occur.

Tax over financial operations, or IOF, also burdens all redemptions made up to 30 days from the date of investment. Rates applicable follow the table below:

Number of days from the investment date

Pro-rata tax incidence over profits (%)

1

96

2

93

3

90

4

86

5

83

6

80

7

76

8

73

9

70

10

66

11

63

12

60

13

56

14

53

15

50

16

46

17

43

18

40

19

36

20

33

21

30

22

26

23

23

24

20

25

16

26

13

27

10

28

6

29

3

30

0

Investments lasting over 30 days are not burdened by the IOF.


9. Advantages

  • Even when investing smaller amounts of money, the investor choosing a fund will observe profits reserved only to larger investments. This happens because he holds a quota part of the fund, but the investment is made considering the fund’s assets, not the investor’s. So, investments reserved to high rollers are also achievable.
  • Operational ease: the investor can move funds using the phone or internet.
  • The investor doesn’t need high levels of expertise: professionals are keeping up with the market daily.
  • Access to a variety of investment types, including those not ordinarily available for smaller amount investors, offering diversification options.
  • Liquidity.
  • The investor can choose from a variety of strategies, when choosing the fund.
  • Income tax payment is the obligation of the fund’s administrator, so the investor needn’t worry.

10. Disadvantages

  • Investment funds are not guaranteed by the Credit Guarantee Fund
  • Some funds tend to concentrate investments on stock or high risk assets. Investors not accustomed to the ups and downs of high risk investments or those that prefer safer choices should not favor funds.
  • High administrative fees may affect profitability.
  • Other such fees, like the ones paid to CVM or Anbima, may also affect profitability.
  • When leaving investment decisions to third parties, one may incur in conflicts of interest between their own objectives and those of the majority of quota holders inside the fund.
  • Leveraged funds may require non-optional further investment should there be significant loss to the fund’s assets.

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