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Overview of investment funds
An investment fund is a financial investment vehicle
or collective investment scheme that has a specific
objective for the benefit of private or institutional
investors. An investment fund pools the financial
resources of various parties and is usually managed
by professional fund managers.
An investment fund sells its shares or units to
private investors or to the public. The proceeds
are invested to achieve its stated objectives. This
facilitates cost-effectiveness through economies
of scale and diversification of investment risk.
It also offers access to markets that may be otherwise
closed to the specific investor.
Shares in investment funds are usually traded at
a value equal to the Net Asset Value (NAV) per share/unit,
sometimes at a premium or discount to NAV. The NAV
per share/unit is calculated based on the current
market value of the investment fund's assets and
liabilities, and the total number of shares/units
in issue.
The investment fund's objectives as set out in
the fund's prospectus, together with its terms and
conditions (sometimes laid out as investment restrictions),
will determine the course that the fund will follow
to achieve its objectives.
Private equity investments are often made through
limited partnerships. These investment entities
will normally have a number of limited partner investors
and a general partner who manages the partnership.
Types of funds
There are many different types of investment fund,
including the following:
Equity funds
Equity funds invest a significant portion of their
portfolio in the stock market and reflect the characteristics
of the market. Equity funds are also known as stock
funds. They may seek capital or income growth, or
a combination of these. They may invest in global
or regional stocks, or in specific industry sectors.
Bond funds
Bond funds invest largely in fixed interest rate
securities with maturity dates. Their value generally
falls as interest rates rise, and they may experience
high volatility depending on the type of securities
chosen. These may range from gilt-edged bonds (government-issued)
to high-yield corporate bonds (high-risk debt).
Money market funds
Money market funds invest in short-term bonds, money
market instruments such as treasury bills, certificates
of deposit, commercial paper, etc. to maintain a
stable net asset value per share/unit. The average
maturity of their portfolios does not exceed one
year.
Hedge funds
Hedge funds typically seek to minimise market risks
or maximise returns by holding securities that are
considered likely to increase in value. Hedge funds
also tend to be short in securities that are considered
likely to decrease in value, and use borrowings
and derivatives. They employ speculative strategies
and invest in a number of markets.
Venture capital funds
Venture capital funds are primarily involved in
the financing of start-up businesses or turnaround
businesses. The typical investment objective is
to benefit from the capital growth of private companies
or enterprises that have entered into negotiated
transactions to form or develop new ideas, products
or processes.
Fund of funds
Instead of, or in addition to, investing directly
in equity, fixed income or other types of investments,
fund of funds invest in other mutual funds with
the same objectives. They offer more diversification
than a single fund, but also have a higher expense
ratio because of the fees for the underlying funds.
Open-end funds vs. closed-end funds
There are two types of investment fund: open-end
funds and closed-end funds. An open-end fund has
an unlimited number of units that can be sold on
demand or redeemed at any time at a price equal
to the NAV per share/unit. A closed-end fund has
a limited number of units sold at the fund's inception.
However, further public offerings may be made at
the fund's discretion. A closed-end fund's units
are not redeemable directly with the fund; instead,
units may be traded on the stock exchange or OTC
market at a price that is either at a premium or
a discount to the share/unit's NAV.
Investment funds sold to retail investors are often
open-ended funds. Closed-ended fund structures are
generally used for private equity or venture capital
funds that invest in securities that are illiquid
and for which there is no readily accessible market
price.
Components and related issues
Principles/concepts
Functional currency
The general principles for determining the functional
currency are applicable to all entities including
investment entities [IAS21.9-14(R.05)]. The functional
currency is the currency of the primary economic
environment in which the entity operates.
IAS 21 lists several factors (e.g. sales prices
and costs) that are relevant in determining the primary
economic environment of the reporting entity. These
factors are not readily applicable to investment
funds. Financing is considered to be a secondary
indicator. Where the indicators are mixed, management
determines the functional currency, giving priority
to the primary indicators. [IAS21.12(R.05)]. The sole
activity of an investment entity is to hold financial
assets on behalf of some investors and to maximise
the performance of those investments.
Determining the functional currency of a fund is
not straight forward. They are often influenced
by a multitude of factors including:
(a) the economic environment(s) in which the financial
assets are invested;
(b) the economic environment(s) of the investors;
(c) the regulatory environment;
(d) the competitive environment;
(e) the fee structure; and
(f) the denomination of subscriptions / redemptions.
When the above indicators are mixed and the functional
currency is not obvious, management uses its judgement
to determine the functional currency that most faithfully
represents the economic effects of the underlying
transactions, events and conditions. A primary objective
of an investment entity is to provide a competitive
return to its investors. Therefore one factor management
will consider in exercising that judgement is the
currency in which the performance of the funds will
be reported to the investors. Once determined, the
functional currency is not changed unless there
is a change in those underlying transactions, events
and conditions.
The selection of functional currency for a fund
is likely to be a critical judgement in the process
of applying the entity's accounting policies that
has a significant effect on the amounts recognised
in the financial statements. Consequently, the preparers
of financial statements should make full disclosure
of the reasons supporting that judgement in accordance
with IAS 1.113 .
Where an investment entity has been set up on behalf
of a single investor, it is likely that the functional
currency of the investment entity will be the same
as the functional currency of the investor .
Taxation
The general principles of recognition and measurement
of income taxes apply to all domestic and foreign
taxes that are based on taxable profits [IAS12.1-4(R.05)].
Income taxes include taxes such as withholding
taxes, which are payable by a subsidiary, associate
or joint venture on distributions to the reporting
entity. Entities are often required to deduct withholding
tax on dividend and interest payments at source.
Many funds recognise dividends and interest payments
received net of this tax. Management should present
withholding taxes that are in substance income tax
as part of the investment fund's taxation expenses
.
The Group
Consolidation of investments held by investment
entities
The general principles of consolidation apply to
all investments that are controlled by an investment
entity [IAS27.9(R.05)].
Investment entities must consolidate all the investments
they control. Control is defined as the power to
govern the financial and operating policies of an
entity so as to obtain benefits from its activities.
Control does not need to be demonstrated or exercised.
Investment entities should consolidate their controlled
investments, even though they are often passive
shareholders with no intention to govern.
Investment entities frequently have complex capital
structures. The rights attaching to each class of
share need to be considered carefully when deciding
who controls the entity .
Many acquisitions made by venture capital funds
are not intended to be permanent. The investments
are acquired and held exclusively with a view to
their subsequent disposal. Even subsidiaries acquired
exclusively with a view to re-sale have to be consolidated.
If a subsidiary meets the criteria to be classified
as held for sale, its assets and liabilities have
to be presented separately on the balance sheet
.
Consolidation of investment entities
The general principles of consolidation apply to
the consolidation of all investment entities [IAS27.19] [SIC-12].
An investment entity should be consolidated by
its controlling party that is the party that has
the power to govern the financial and operating
policies of the investment entity. The identity
of the controlling party will depend on the following
factors:
| 1. |
The ability of
the investment manager to make real investment
and other decisions; |
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| 2. |
The existence of any rights
to remove the investment manager; |
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| 3. |
The existence of any other
interest held by the investment manager or its
affiliates in the investment entity; and |
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| 4. |
Any other statutory, contractual,
legal or regulatory constraints on the power
of the investment manager. |
An investment manager with real decision-making
powers who cannot be removed immediately and who
has a significant economic interest in an investment
entity may have to consolidate that entity .
The offering document or regulatory environment
of the investment entity may impose strict and permanent
limits on the decision-making powers of the entity's
governing boards, trustees or management over the
operations of the entity - it may therefore operate
on 'autopilot'. In this situation the investment
entity is an SPE and SIC-12 applies .
Private equity limited partnerships normally have
a number of limited partner investors and a general
partner who manages the partnership. In certain
circumstances, the general partner may be deemed
to control the limited partnership. If this is the
case, the general partner may be required to consolidate
the limited partnership .
Classification of investment entities as associates
The manager of an investment entity will, in general,
have significant influence over that entity. Consequently,
where a fund manager is also an investor in the
fund, the fund will meet the definition of an associate
.
Presentation of financial statements
Structure and content of financial statements
The general principles of presentation apply to
all financial statements prepared by investment
entities [IAS1.13-14(R.05)] .
The presentation of financial statements for investment
funds is often influenced by the prospectus or offering
documentation. These documents may require the disclosure
of detailed additional information about the fund's
assets, such as the disclosure of investments and
the inclusion of an investment portfolio. Comparative
information should be included for all narrative
and descriptive information .
Regulatory requirements may sometimes require the
presentation of non-GAAP measures. Non-GAAP measures
should be presented outside the financial statements.
However, non-GAAP measures may be presented in the
notes to the financial statements as long as they
are reconciled to the equivalent GAAP measures and
are not given greater prominence than the GAAP measures
.
Reporting financial performance
Earnings per share
The general principles for calculation of basic
and diluted earnings per share apply to all financial
statements prepared by investment entities [IAS33.2-4(R.05)].
Often investment entities have issued different
classes of shares. Some of the classes might be
publicly traded. When the shares that are publicly
traded meet the definition of ordinary shares, basic
and diluted earnings per share have to be presented
.
Financial instruments
Classification of financial liabilities
The general principles of classification of financial
liabilities apply to all investment entities' financial
liabilities [IAS32.15-27(R.05)].
Open-ended investment entities typically issue
redeemable preference shares or units. These shares
tend to be redeemable at the holder's option, at
the NAV on redemption. Such instruments have traditionally
been classified as part of the fund's equity under
local regulatory requirements. Puttable instruments
meet the definition of a financial liability under
IAS 32R. They represent an obligation for the issuer
to pay cash. Many investment funds will need to
reclassify their 'shares' as liabilities. This has
consequential implications for the presentation
of the statement of changes in equity of investment
funds .
Classification of financial assets
The general principles for classification of financial
assets apply to all investment entities' financial
assets [IAS39.9(R.05)].
An open-ended fund should not classify any financial
asset as held-to-maturity. Calls for redemption
of shares or units could frustrate the fund's ability
to hold its investments to maturity, although management
might intend to hold the investments to maturity
.
Measurement of financial assets and financial liabilities
The general measurement principles for investments
apply to all classes of investment entities' investments
[IAS39.43-47(R.05)] [IAS39.AG69-82(R.05)].
When a financial asset is initially recognised,
an entity shall measure it at its fair value plus,
in the case of a financial asset not at fair value
through profit or loss, transaction costs that are
directly attributable to the acquisition of the
financial asset .
When a financial liability is initially recognised,
an entity shall measure it at its fair value plus,
in the case of a financial liability not at fair
value through profit or loss, transaction costs
that are directly attributable to the acquisition
of the financial liability. Where a financial liability
issued is repayable on demand (for example, redeemable
shares issued by a fund) it should be carried at
the amount that is payable on redemption .
Many funds, in accordance with the provisions of
the fund's prospectus, are required to value their
quoted investments based on the last traded price
or the average of the last bid and ask price at
the close of business on the relevant trading day.
This is in order to determine the Net Asset Value
('NAV') for share subscriptions and redemptions.
Investment funds reporting under IFRS are required
to value quoted investments at the latest quoted
bid price for financial reporting purposes [IAS39.AG72(R.05)]
, .
A requirement to value investments in accordance
with the provisions of the fund's prospectus may
create two valuation results for quoted investments.
An investment fund may choose to provide a reconciliation
between the IFRS NAV and the adjusted NAV calculated
in accordance with the prospectus .
Investment entities that invest in private equities
cannot rely on published price quotations. The fair
value of such an investment has to be determined
by using a well-established valuation technique.
There is a presumption in IAS 39R that it is possible
to estimate the fair value of a financial asset
acquired from a third party. A cost based valuation
is therefore not acceptable. Only in very rare circumstances
where the variability in the range of reasonable
fair value estimates is significant and the probabilities
of the various estimates within the range cannot
be reasonably assessed, e.g. for certain early stage
investments is a cost based measurement justifiable.
A client specialised in private equity should have
systems in place that enable them to value substantially
all of their investments [IAS39.AG74-82(R.05)] .
Impairment of financial assets
The general principles of impairment apply to the
measurement of all investment entities' financial
assets [IAS39.58-70(R.05)] [IAS39.AG84-93(R.05)].
Unless a fund's investments are classified as at
fair value through profit and loss management must
assess, at each balance sheet date, whether there
is objective evidence that an investment is impaired.
Investment entities often classify their investments
as available-for-sale. If the recoverable amount
of an available-for-sale investment is below its
original acquisition cost, the cumulative net loss
that had been recognised in equity should be removed
from equity and recognised in profit and loss for
the period. Various indicators have to be considered
in assessing whether an investment is impaired.
Revenue
Service revenue
The general principles of revenue recognition and
measurement apply to all financial statements prepared
by investment entities and investment managers [IAS18.20-28(R.05)]
[IAS18.9-12(R.05)].
The compensation for services provided by an investment
manager for an investment entity often depends on
the performance of the investment entity's investments.
If the amount of performance-based revenue cannot
be measured reliably the investment manager should
not recognise revenue associated with the services
provided to the fund .
Revenue includes only the gross inflow of economic
benefits received and receivable by the entity on
its own account. Investment managers often act as
market makers for the shares of the funds they manage.
If the investment manager is not exposed to the
significant benefits and risks associated with the
selling price of the shares, their proceeds should
be excluded from the income statement of the investment
manager .
Investment managers may receive an up-front fee
for setting up the fund and putting the investment
strategy in place. In other cases the investment
manager receives a higher annual fee that includes
the compensation for setting up the fund. Fees that
are earned on the execution of a significant act
should be recognised as revenue when the significant
act has been completed. It is seldom possible to
distinguish one service as more significant than
another service being rendered. If two or more services
rendered cannot be clearly distinguished, the fees
received should be recognised over the life of the
contract. This assessment requires judgement in
each case in the context of all relevant factors
.
Incremental costs that are directly attributable
to securing an investment management contract are
recognised as an asset if they can be identified
separately and measured reliably and it is probable
they will be recovered [IAS18.Appendix14(b)(iii)(R.05)]
.
Funds may apply a process of equalisation to their
net assets. Equalisation is the process whereby
existing fund members are compensated for the dilution
of their interests arising from new entrants to
the fund. Equalisation amounts are neither income
nor expense as defined by the framework nor does
equalisation give rise to assets or liabilities.
Consequently, equalisation does not impact on the
financial statements .
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