A fund invests in a fund – where does the money go in the end?

Instead of investing directly in equities and bonds, pension funds prefer to put their money in different investment funds. Was such a solution chosen for better risk diversification, convenience, or are there other reasons? And still, where does the money go in the end?

Risk diversification

When we look at the investments of the SEB Progressive Pension Fund, we will find funds whose investments reveal that Intel, Samsung, Facebook, and many other well-known stock companies are part of the biggest equities. Via these fund investments, there are approximately 6,000 different securities and financial instruments from nearly 70 countries. It is inconceivable that information related to such an amount of direct investments could be handled by one single team. Competitive direct investing in equities and bonds requires focusing on a certain investment strategy and probably also on a specific region. If a pension fund only handles direct placements, it might lead to a risk of unduly one-sided placements. By investing via other funds, the investment areas can be expanded and variegated by involving different teams for both risk-spreading and raising revenue potential. It is also important that investments via funds give the flexibility to change strategies and asset classes in order to lead investments in the desired direction.

Cost vs return

Active investments require the management company to spend more on staff, information systems, and above all, time for proving the investment process. Therefore, a higher management fee is justified in the case of actively managed funds, but the fund performance may not always justify the costs. Thus, the choice of funds, i.e. the assessment of the management company’s investment process, team, and organisational arrangements is extremely important. It is equally important to see the management company’s potential, as well as the possible bottlenecks.

Focus

Investing in financial markets is a highly competitive action. In the long-term, the management companies, who are able to maintain the necessary focus for rewarding investments, are more successful in the long-term. The management of pension funds is based on the investment portfolio, i.e. the division of asset classes. That way, the pension fund as an institutional investor can involve the world’s top know-how via other funds, which will in turn enable the pension fund to concentrate on the most important thing from the perspective of the customer, i.e. the allocation of assets. This does not mean that the choice of funds is secondary. On the contrary, finding productive funds requires a deep insight into the activities of the organisation.

Options

Estonian pension funds have the possibility of putting money in most successful funds. The advantage of SEB pension funds is belonging to the SEB Group, as agreements have been concluded for low-cost management fees in making investments in funds managed in this group, as well as in funds managed by many other management companies.

Pension funds also invest in passive index funds, whose aim is to achieve the rate of return of a certain financial index. The purpose of involving passive funds is to make investments with the lowest possible cost in areas where it is very complicated to outperform the return of the index by active management. However, it must be taken into account that in the case of index funds, the result of the investment depends on the rules of the index and the market situation, and not on the motivation of active funds to use market opportunities and manage risks.

Vahur Madisson
Fund Manager