Choosing the right place to grow your money can be hard, especially for those new to investing. Investment funds can make the process easier, safer and more accessible. But it’s important to understand how funds work before trusting one with your money.
In this article, we run through all the basics and things to consider before deciding which fund is right for you.
What are investment funds?
Investment funds can have a range of different names. You may have heard the term ‘mutual fund’, ‘unit trust’, or ‘exchange traded fund’. All of these are types of investment funds.
Although they come in different forms, all funds have one important thing in common: they pool the money from many investors to buy a range of assets. Rather than owning these assets directly, you own units or shares in the fund. As the total value of the assets held by the fund rises and falls, so does the value of your holding in the fund.
How do funds work?
The easiest way to illustrate how funds work is to look at an example fund.
Major US investment manager Fidelity runs a mutual fund called the International Growth Fund. This has a defined objective, which is to seek long-term capital growth. And it has a defined strategy: to invest primarily in shares across the world excluding the US. On 31st October 2022, it was invested in 79 different companies and its share price was US$15.05. This means that it would cost US$15.05 to buy one share in the fund and that money would be spread across the 79 different securities held by the fund.
As the values of the shares in those companies rise and fall, so does the value of each share in the fund. On 1st November the price was US$15.15, meaning that the prices of the shares held by the fund had gone up slightly. In reality, some would have gone up and some would have gone down, but there was an increase overall.
What are the different types of funds?
Mutual funds vs Exchange Traded Funds (ETFs)
These are the two types of funds commonly found across the world. As with all investment funds they hold a basket of different securities. The difference is how they are traded.
‘Mutual fund’ is the general name given to a fund that is traded once a day based on a single daily price. That price is determined by the current value of the assets held by the fund. If you place an order to buy or sell, your order is usually executed later that day, or on the following trading day, along with orders placed by other people during the day.
ETFs, meanwhile, are traded like shares on a stock exchange with a price that varies throughout the day. This means your order is executed immediately at the current price. It’s also possible for the price of the ETF to be slightly higher or lower than the value of the assets held by the fund, depending on how in demand the ETF’s shares are.
Active vs Passive Funds
Funds are typically managed in one of two ways – active or passive.
With actively managed funds, the assets are picked by a professional investment manager who is trying to outperform a particular benchmark over time. By picking the right investments, they aim to generate better returns for their investors.
Passive funds, sometimes called ‘index’ or ‘tracker’ funds, track the performance of a particular index. For example, it may seek to track the performance of the S&P 500 index in the United States. If that index goes up, so do the returns of the tracker fund.
The benefit of active funds is that they can outperform the market through well-chosen trades. But there is also the possibility of underperforming the market. Passive funds can only track the market. This means they can’t outperform, but the risk of underperformance is also removed. They generally also have lower management fees than actively managed funds.
Most ETFs are passive funds, whilst mutual funds can either be active or passive.
Fund sectors
Funds are divided into different types based on the assets they invest in. These help investors to identify which funds might be suitable for them and also allow the performance of similar funds to be measured against each other. Once a fund is allocated to a sector, it has to be managed within the constraints of that sector. There are many different categories and sub-categories used across the world, but the main broad categories are:
Equity Funds
These primarily invest in company shares. There are many different sub-categories, which may be based on the geography that the fund focuses on (e.g. Europe, emerging markets) or the types of companies it invests in (e.g. technology, small companies).
Bond Funds
Bonds are loans to a company or a government. Investors buy them in return for interest payments from the issuer. Bond funds invest in these loans and their value can rise or fall depending on economic conditions and the issuer’s credit rating. Again, there are many subcategories depending on geographic location, and the type and creditworthiness of the issuers that the fund targets.
Specialist assets
Some funds focus on other types of assets. These could include property, commodities such as oil or gold, or major infrastructure projects. Again, there are many sub-categories. These funds allow investors to diversify their holdings further and invest in specific categories they are interested in.
Mixed Asset Funds
Some funds invest in a blend of different assets. These are typically equities, bonds and other assets such as property. Mixed asset funds may target a defined risk level, or a particular rate of return, although there is no guarantee they will achieve their target. These funds can be useful for beginner investors because they usually offer a high level of diversification in one fund.
How do funds achieve a return?
Funds can achieve a return for their investors in two ways. The first is capital growth: an increase in the value of assets. This might be company share price growth or an increase in the value of a commodity such as gold.
The other type of return is income. This might be interest from bond or cash investments, or dividends issued by companies.
Some funds focus on capital growth by investing in assets that are expected to grow but don’t generate much income. Others focus on investments that are not expected to grow strongly but generate a reliable income stream. And some achieve returns through a mix of both.
How much does it cost to invest in a fund?
The convenience of investing in a fund doesn’t come for free. There are charges to cover the cost of managing the investments and running the fund, wrapped up into an annual management charge (AMC). This is a percentage of the money held in the fund. The higher the AMC percentage, the more each investor pays for the fund to be managed. There are also usually additional fund expenses on top of the AMC to cover costs such as buying and selling of assets within the fund. All of the costs and charges together are usually expressed as a ‘total expense ratio’ (TER).
For example, the Fidelity International Fund we looked at above has (at time of writing) a TER of 0.99%. If an investor has an average of £50,000 invested in the fund over a year, they will pay 0.99% of that, which is £495 for the year.
Funds should disclose these costs to investors in their documentation. The charges are taken from the returns generated by the fund.
What information is provided by funds?
Each fund should publish regular information to allow investors to understand how it operates. This would include a fund’s objective, how it intends to achieve it (its investment strategy), its major holdings, and the costs and charges. It’s also important to understand a fund’s track record by looking a past performance compared to its benchmark. Remember though, just because a fund has had good performance in the past, that doesn’t mean it will continue to do so in the future.
The most important information is usually found in a Fund Factsheet, which funds typically issue monthly for their investors.
Benefits of investing in a fund
For many people interested in investing, funds are the starting point. Here are some of the reasons that they are so popular:
Diversification
This is one of the biggest benefits of investment funds. All investments come with some level of risk, but a powerful way to manage risk is to spread your money across many different assets. This way, if one of your investments falls considerably, this can be compensated by other assets increasing in value.
Convenience
With a fund, there is no need to spend time choosing or monitoring lots of individual securities. You can also get easy access to investments that it might be difficult to buy as an individual, such as property, or investments traded on exchanges overseas.
A low entry threshold
If you’re investing in individual securities, buying enough to ensure effective diversification would require a significant amount of money. By contrast, you only need to invest in one fund to get good diversification. Some funds have very low initial investment amounts, which means it’s possible to start investing responsibly with very little money.
Professional Management
Actively managed funds are run by a fund manager whose job is to select suitable investments and optimise returns for investors. They have access to data and analysis that individual investors typically don’t. In theory, this gives an advantage, although it’s no guarantee of success.
Although managers of index funds don’t pick stocks, they do use systems to ensure that they track their chosen index accurately. This is difficult for individuals to do outside of a fund.
Top 5 considerations for choosing an investment fund
Each fund has a different approach. The challenge as an investor is to find funds that match your objectives and circumstances. Here are the top 5 things to consider when choosing a fund to invest in:
1. What do you want to achieve? Think about what you want from the fund and what role it will play in your portfolio. Do you want capital growth or to generate regular income? Do you want to invest in environmentally responsible investments?
2. What assets do you want to invest in to achieve your objective? You need to identify a fund or mix of funds that invest in the right assets in the right proportions for you.
3. What is your preferred investment style? Do you want an actively managed fund to try to outperform the market? Or would you prefer a fund that tracks a particular market?
4. How much does it cost? Charges can vary considerably by fund and can eat into your returns. Usually, passive funds have lower costs and charges than actively managed funds.
5. What is the fund’s track record? The performance of a fund, especially an actively managed fund, is largely due to the skill of the fund manager and their team. So, it’s important to understand how successful they have been at meeting the fund’s objectives in the past, although that is no guarantee of success in the future.
Interested in Investing?
Investing can be daunting but also rewarding if you do your research before leaping in.
Tukki can help you get started with investing. Have a look at the other articles in our Investment Academy.