The Investment Fund Industry in Denmark

A revitalized industry

With DKK 676 bn under administration at the end of 2008 the Danish Investment Fund Industry is steadily gaining greater importance - also in a European context. The Danish market share of the total European industry is - however - still low. This is not only due to the limited total financial assets in a country with approximately 5 million inhabitants, but also a reflection of a relatively underdeveloped investment industry in the country. This is partly due to savings habits in Denmark - the tax system benefits institutional pension savings, direct bond ownership is widespread and based on an age-old tradition, while private equity investments have had a late start, and last but not least, the banking system offers relatively high yielding savings deposit rates.

While collective investments actually date back to the late 1920s, the first investment funds appeared in the late 1960s, promoted especially by savings banks (Sparinvest) and provincial banks (BankInvest) as special investment vehicles. In the early 1980s, the concept took off, partly due to tax incentives and partly due to liberalization of foreign portfolio investments. The large banks all promoted investment funds that specialized in foreign equity. This led to fast growth of the industry for a few years, only to come to an abrupt stop in 1987, under the combined influence of "Black Monday" on the global equity markets and a restructuring of the Danish income tax system, which had severe repercussions on saving patterns. Up until the early 1990s, investments in the funds were in constant decline and only stabilized in 1992.

Since that year however, a resurgence of the industry has been under way. The normalization of the savings pattern, combined with falling interest rates and an increased awareness of the benefits of collective fund management have led to a continuous capital inflow, which indicates that the industry has come of age and is securing its presence as an important abode for medium term savings and long term pension investments. Especially after the year 2000, the industry has grown - also under influence from a large inflow from institutional investors and economic growth and demographical development supporting demand from private investors.

The legislation

Before 1982, there was no specialized official regulation pertaining to investment funds, but the fast growth at the beginning of the decade resulted in the formation of a special committee which recommended formal legislation on investment funds, inspired by the proposal for the UCITS-directive, which was under way in Brussels. The Act was accepted by Parliament and entered into force the following year, and - apart from the necessary revision due to the UCITS-directive of 1989 - Danish investment funds remained in the original mold, tightly circumscribed by the UCITS-directive in a conservative interpretation, until 1998.

Danish funds therefore, had only very limited possibility to take part in the strong development of investment funds products and practices, which took place during the last decade. This resulted in a proposal for a modernization of the Investment Fund Act, which entered into force in January 1998.

The new law preserves the special form of organization of the Danish investment funds (cf. below) and - by introducing non-UCITS "special funds" - opens up for investment policies better suited to the Danish capital market tradition. This allows pure mortgage bonds funds, as mortgage bonds are preferred investment objects among Danish savers, index-funds, which can copy the Copenhagen Stock Exchange KFX-index, guaranteed funds as well as money market funds and fund-of-funds. The possibility of creating semi-closed special funds investing in unquoted shares of small and medium sized companies was also introduced.

The Danish Funds are supervised by the The Danish Financial Supervisory Authority.

Organization

The legal entity of a Danish investment fund is an association in which all investors are members and where the membership entails right to vote at the General Assembly, which is the highest authority. The General Assembly chooses the Board of Directors and appoints a Manager and the Depositary. The Manager is usually a limited company, fully owned by the association.

The management company must only service investment funds. This limitation, which is based on the UCITS-directive, has been introduced to ensure that the professional fund managers use their best effort to the benefit of the usually less professional fund and thus avoids conflict of interest. The custodian must be a Danish bank, and it is often the promoter of the investment fund, as reflected in the investment fund name.

It is, however, important to stress the independence of the investment fund and its managing company of the promoting bank. It is a clear-cut business relation, and the promoter-banks usually also sell other funds than the one they promote. There have been several examples of investment funds changing promoter as well as custodian bank.

The investment funds and their management companies are under continuous surveillance by the Danish Financial Supervisory Authority.

At the time of writing (January 2009), there are nearly 800 investment funds/division of funds, managed by approx. 30 fund management companies (see further information). Each division has separate accounting, ensuring that costs connected with the specific investment policy are borne by the division itself.

The professional organization of the Danish investment funds is InvesteringsForeningsRådet (The Federation of Danish Investment Associations). The associations are represented by their management companies. While membership of the Federation of Danish Investment Association is not compulsory, all associations with a Danish incorporated management company are members.

Pricing of investment fund shares

It is a basic principle of investment funds that shares are issued and redeemed on demand without any limitations at a price, which always reflect the true value of the fund. This differs from pricing system for bonds and shares on an exchange, where demand and supply in the market, at a given moment, is the price-determining factor. Shares in incorporated investment companies, which are often confused with investment fund shares by lay investors, do not have this fair exit guaranty and can under certain circumstances - usually when exit is the most appropriate action - be untradeable at any reasonable price.

Investment fund shares are as a principle "value transparent", i.e. the full value of the funds investment portfolio is always reflected in the value of the share. The portfolio of bonds and shares are almost all quoted on a (Danish or foreign) stock exchange, and the value of the portfolio is calculated several times daily using the most recent market quotation. Total market value of portfolio at the beginning of the day/number of outstanding shares at the beginning of the day. Each share (usually with a face value of DKK 100, approximately Euro 13) has an intrinsic value - net asset value - equal to the (total market value of the portfolio/number of outstanding shares).

Example: The market value on a given day of the portfolio of X Fund is DKK 16.536.200. The number of certificates in circulation the same day is DKK 119.379. The n.a.v of a fund share is DKK 138.52.

The official purchase and sales price for shares are based on - but not necessarily equal to, the net asset value. When a new investor buys into a fund, the proceeds are used by the association to buy more securities in the market. The transaction and marketing costs in this connection must be borne by the new member so as not to increase costs in the fund, which will reduce existing members' result. These transaction- and marketing costs are added to the intrinsic value, creating the issue price.

The opposite holds true when a member redeems his fund shares. In order to obtain cash, the association sells securities in the market, giving rise to transaction costs, which must be borne by the redeeming member. The redemption price will be slightly lower than the intrinsic value as the selling costs are deducted.

Issues and redemptions usually take place in a continuous process, and in many cases a new buyer might pick up a fund share sold in a bank shortly before. In this case no change in the underlying fund portfolio takes place, there are no transaction costs and the customers will - from the fund's point of view - not add to expenses. Issue and redemption price equals the intrinsic value, and the only cost for the customer will be the ordinary banking fees. As net issues and redemptions seldomly balance out exactly, investment fund shares can sometimes be purchased a little below the intrinsic value (when there are net redemptions) or sold above this value (when there are net issues). This price-to-book value ratio usually vary between 0.97 and 1.05, depending on the demand situation and the type of assets in which the fund invests - domestic bond funds are usually closer to 1 than e.g. foreign equity funds which often have significant trading costs.

When investment funds shares are bought or sold through a bank, it will usually charge a commission from the private investor as on ordinary share dealings. In Denmark, the bank commission is usually up to 0.75 per cent of the value of the transaction with a fixed minimum and maximum for both purchases and sales. Many banks offer shares at lower rates - for instance through net banking.

On the other hand, banks offer fund members custody and administration of shares of the investment fund they promote free of charge. All shares are registered electronically at "Værdipapircentralen" - VP Securities Services.

The cost structure of investment funds

The current expenses associated with day-to-day business of the fund, i.e. other costs than those directly attributable to the change in investments due to a change in the capital of the fund as a result of issues/redemtions, must be covered by the fund. These expenses are deducted from the income of the funds before dividend payments on the shares.

Due to economies of scale, large funds have as a rule lower relative cost than funds with limited capital under management. A special case is the so called "whole sale funds" with a small number of very large investors. Administrative expenses vary from fund to fund. The expenses are normally higher in retail funds than in institutional funds. And the expenses are normally higher in equity funds than in bond funds. The Danish funds have relatively low TER's in an international context.

When the return on investment fund shares are calculated the fact that the return figure is calculated net of costs must be taken into account. When returns are compared with market indices - e.g. Morgan Stanley's Danish Bond Index - the latter does not take buying, selling and custody costs into account. The net return of a private investor with a portfolio with the same composition as the index cannot expect a return equal to the indexes. The cost deduction in relation to the index decreases with the size of the portfolio, but for most small retail investors, these costs add up and result in lower net returns than through investment funds with a performance comparable to the index.

The services offered by investment funds

Such a comparison is based on a passive investment policy. i.e. a "buy-and-hold strategy" - after the initial investment has taken place, only reinvestment of interest and repaid principal takes place.

However, part of the costs in the investment funds reflects an active management of the portfolio in the fund. Based on the expected future performance of the securities markets, the management company will try to optimise the portfolio by selling securities it considers overvalued, buying undervalued securities or hedging the present value by using financial derivatives.

The authorities tightly regulate the use of financial derivatives in Danish investment funds. A fund cannot take on larger derivative commitments than equal to the capital present in the fund. It can hedge the market risk of the securities and the future income stream, but it is forbidden to open up speculative positions. This is contrary to the techniques used by so-called "hedge funds" and "forex pools", which take on future commitments larger than their capital. This type of "gearing" will in volatile financial markets result in large gains and losses of capital. As experience shows that losses are just as common as gains, Danish investment funds are strictly prohibited from gearing.

Development on the Danish fund market since the millennium

At the end of 2009, total assets under management was DKK 809bn. The Danish fund market remains small in a European context. However, private fund members reached app. 830-840,000, which correspond to 16% of the Danish population. Funds aimed at institutional investors - mainly "non ucits" - is app. 50% of the total assets under management.

Further information

Telephone (+45) 33 32 29 81, Fax (+45) 33 93 95 06 e-mail info@ifr.dk

Last updated 1-15-2010