INVESTMENT BASICS – INVESTMENT OBJECTIVES

INVESTMENT BASICS – INVESTMENT OBJECTIVES

Defining the Investment Objective is a crucial element for any investment fund. It  serves to disclose and clarify the correlation between the anticipated risks and returns that the fund is willing to embrace. The Investment Objective is a cornerstone information to be disclosed in the offering documents of any fund as it will allow the investor to make an educated decision whether to invest or not in a fund.

In this article, we will explore and breakdown opened-ended and closed-ended fund’s four basic types of Investment Objectives, how to identify them, and what are the key elements that differentiate each one of them.

Every investment fund has an overall goal that is aligned with the requirements of its investors and it is proportional to the risk appetite of those investors. The risk level of the Investment Objective depends on the type of investments within the portfolio. The fund’s manager and/or its general partner should always follow a defined, and previously disclosed, investment strategy that match the risk appetite in order to achieve the Investment Objective.

Together with the investment strategy, the offering documents of the funds should inform what investment instruments and products are going to be targeted to achieve the Investment Objective. Considering the above, the investment products that form the assets of these funds will differ according to its objectives.

The objectives of closed-ended and opened-ended funds are normally four;

  1. Safety of Capital,
  2.  Income,
  3.  Growth and
  4. Tax Saving.

Each of them may bed is closed or named in the offering documents throughout sub-objectives that may further breakdown the risk vs return correlation within these main four Investment Objectives.

1) Safety of Capital

Safety of Capital is an investment objective that is also known and commonly referred to as Capital Preservation. These funds will aim for less risk and generally will provide a lower rate of return than funds with other objectives. This Investment Objective is most commonly used by opened-ended funds that invest in highly liquid and short-term instruments like the money market mutual fund who characterizes for purchasing and selling large volumes of cash, cash equivalent, and debt-based securities.

We would like to take this opportunity to reiterate that even if Safety of Capital may be the Investment Objective with the lowest risk there is no such thing as an absolutely safe and secure investment, and there is none that is completely riskfree.

Safety of Capital funds main target is to keep up with inflation and they will look for investments that have a minimal risk level that will correlate to a lower rate of return, as safest investments tend to. These “safe” investments generally include financial instruments such as; government issued bonds from countries with stable economic environments, high-quality corporate bonds and securities guaranteed by banks.

In the realm of Safety of Capital, a slightly more advanced tier in terms of risk introduces the first sub-objective: Safety of Principal. This fund objective is characterized by investments in secure debt securities with longer time horizons. The longer time frame typically brings about higher price volatility.

2) Income

Income is an investment objective that is also known and commonly referred to as a Dividend. A closed-ended and/or opened-ended fund with Income as its Investment Objective will undertake a higher risk investment strategy and will
invest in higher risk assets than, for example, a money market fund, however, the expected returns will be higher than those of an fund with Income as its Investment Objective.

Investment managers and/or general partners of Income funds will seek for those instruments that may guarantee a supplemental steady income and will show a tolerance for higher risk in order to achieve that steady income.

The most commonly recognized Income funds include domestic and international bond funds, equity income funds, and mortgage funds, as these represent typical investment vehicles with income as their primary objective.

The Income funds, due to the nature this objective, can be considered as asset allocation driven funds as not all instruments will provide an income and therefore, the investment manager will have limited strategies such as “spread trade” and “interest rate anticipation” to achieve this objective.

Many Income funds may seem unbalanced and lacking of diversification of portfolio risk due the limited number of investment instruments and assets to invest in.

Notwithstanding the above, the investment managers providing services to Income funds may try to avoid the lack of diversification by combining the three main assets and invest in bonds, certain equity and mortgages.

Within each type of Income fund, the risk profile may differ depending on each asset. For example, the rate of corporate bonds is riskier that government bonds but tends to yield a higher return. They could be high quality bonds with a lesser risk or low-quality known as junk bonds, and the same may apply to mortgage funds, and/or to income equity funds that invest in stock with a good history of paying dividends compared to those with an unproven tracked record.

3) Growth

Also known and commonly referred to as Capital Appreciation, those funds that have growth as their investment objective provide investors with a diversification of the portfolio risk and may primarily invest in ordinary stocks and sometimes preferred shares. In many occasions, they are also referred to as equity funds.

Growth funds tend to provide better returns but they also carry a higher risk than Income funds.

Growth funds might be a primary objective for investors who are normally less concerned with safety and are not interested or do not totally depend on receiving income from their investments in different investment funds.

This type of investment funds that focus their strategies on achieving growth through investing in instruments that are more likely to fluctuate in value and aim to cover the greater risk of loss with higher return investments.

While these funds may offer greater long-term returns, they may experience fluctuations in its valuations along the way. This underscores the importance for these Growth funds to inform investors about potential risks, ensuring they are aware and prepared in advance.

The funds that invest in highly liquid assets, e.g. publicly traded companies, are usually associated with growth and are generally considered highly speculative, while growth investment instruments offer considerable opportunity for increase in value there is also the potential of a greater risk of loss.

There are hybrid funds that may combine Income and Growth objectives by investing in blue chip stocks that could offer a relative lower risk by allocating part of the pool of funds into shares of well-established and mature companies, thus their growth is primarily related to the long-term growth of the company while many blue-chip stocks also offer a dividend. These funds should inform their investors that dividend payments are not guaranteed but they may offer investors some form of predictable gains by income generated in common shares.

This objective is the most popular among offshore funds using a large array of sub-objective like absolute return, capital appreciation, adjusted risk vs return and/or aggressive return.

4) TAX SAVING

Tax Saving funds, also known and commonly referred to as Tax Managed Funds, focus on the general idea that in most jurisdictions taxes on capital gains are significantly lower than taxes on income derive from interest or dividends and the taxes associated to an ordinary income like salary.

When the primary objective is Tax Savings most investors will focus on registered plans such as registered retirement savings plans and tax-free savings accounts as they usually are the best bet.

These Tax Saving funds are usually more expensive than funds with the objective discussed above that do not have to allocate resources to focus on that layer of tax management. Therefore, these funds will target those investors that are in a higher tax bracket.

Popular funds structures that target these investors with a tax saving objective may offer investment products with different names depending in which country they are based, like the equity-linked saving schemes (“ELSS”) in India, which offer tax benefits to the investors under Section 80C of the Income Tax Act, 1961 and/or like in the UK with the Enterprise Investment Schemes (“EIS”) and the Seed Enterprise Investment Schemes (“SEIS”) that are designed primarily to encourage investment into early-stage companies and promote growth across the UK’s next wave of innovative start-ups and scale-ups.

The Investment Objective of a fund is a critical piece of information that must be included in the offering documents, as it is essential for any investor contemplating an investment. Without a clear understanding of the investment objective, investors may struggle to make informed and educated decisions about whether to invest in the fund or not. It underscores the importance of comprehending the Investment Objective, as any alterations to it after the fund is launched would necessitate consent from existing investors.

For specific guidance on the features and benefits of any of the funds discussed above and how to launch them and get them registered with the Cayman Islands Monetary Authority, please contact your usual Vale Law attorney or any of:

Shelley Do Vale: shelley.vale@valelaw.ky
Santiago Mtnez-Carvajal: sc@valelaw.ky