Everything from Oeics, investment trusts and ETFs to active vs passive strategies.
Most people start their investing journey by choosing a fund. Here your money is pooled with that of multiple other investors like you. It’s then managed by a professional who makes investment decisions on your behalf, whether active or passive.
But there are more than 5,000 funds to choose from, so it can be an overwhelming decision if you’re not sure what you’re looking at. To help, we’ve broken down the different types of funds and what they do.
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What is a fund?
All funds are ‘collective investments’. When you buy into them, you’re pooling your money with contributions from other investors. That means you can get exposure to many more investments than you would with your own money. And you can often start with as little as a £100 lump sum or £25 a month.
There are four different types of funds as you may find that you prefer one type of fund structure over another. But you can actually start investing with all three types because within each category you’ll be able to find funds suitable for beginners.
Further down the line, you might want to put together a portfolio of different types of funds. You could start investing with one or two funds and then aim to eventually build a diversified portfolio made of 5-10 funds, ideally managed by different firms and investment managers to spread your risk.
If you were buying single shares in a company, you might find that it sometimes costs £100 to £300 to just buy one share, particularly shares in some of the bigger most well-known companies in the world such as the big US tech names. That means you’ll need a few thousand pounds to create a portfolio that spreads your risk between lots of different companies.
Instead, you could take your £100 and put it into a fund, and instantly get exposure to shares in thousands of well-known companies around the world.
For someone with a busy life and no time to research individual shares, choosing a passive fund or handing the day-to-day running of your money over to a professional is a big attraction of funds.
Active vs passive funds
Investments in funds can be managed in two different ways – active and passive.
Active funds are run by a professional fund manager who selects the investments and aims to outperform a benchmark such as a relevant stock market index or other similar funds in the same fund sector, or both.
With active funds there’s the opportunity to get better than average performance, but there’s also the risk that the fund manager makes the wrong call and underperforms the benchmark.
Passive or ‘tracker’ funds mirror or track the performance of a benchmark or index, such as the S&P 500 in America or the FTSE 100 index of the largest UK companies. This means you’ll get average performance, but the risk of underperforming is lower.
Passive funds typically have lower charges than active funds and are popular as investors realise the advantages of keeping costs low.
You can of course have a mix of passive and index funds, getting the best of both options.
Exchange Traded Funds (ETFs)
The newest form of fund is an exchange-traded fund (or ETF). They have been growing in popularity as simple, low-cost tools for getting access to a range of companies, commodities and countries. They are particularly good for providing exposure to a particular investment theme, such as energy or technology.
ETFs trade on a stock exchange, and you can buy or sell them at any time during trading hours at the price shown. But the price will go up and down depending on investor demand.
One advantage of ETFs is transparency. With open-ended funds or investment trusts (more on these in a moment), you generally don’t see the changes to the underlying holdings every day. In fact, with an open-ended fund you only usually see the top ten holdings. But with an ETF you can usually see all the underlying investments every day because the vast majority track a specific stock market index, such as the FTSE 100 or S&P 500.
But not all ETFs actually hold the underlying investments. When investing in stock markets they will use ‘physical’ or ‘synthetic’ replication to create the same performance as the index. Physical replication means buying a small share in each of the underlying investments in the index. But synthetic is a way of recreating the index return by using complex financial derivatives, such as futures and ‘swap agreements’.
Most ETFs are passive, but active ones are available and on the rise.
Index funds
These are similar to passive ETFs, in that they track particular indices, such as the FTSE 100 or S&P 500, but they are open-ended funds (see below).
Open ended funds (Oeics)
In the UK, ‘open-ended’ funds are now much more numerous than investment trusts and are marketed more strongly to the public.
Open-ended means there is no limit to how many people can invest in it or how much money can be invested. The fund expands and contracts depending on how many investors put money into it or take money out. Open-ended funds can be active or passive.
There are generally two different types: unit trusts and open-ended investment companies, known as Oeics for short.
With unit trusts the fund is split into units that investors buy. Unit trusts have a ‘bid-offer spread’ where the investor pays more to buy units of the trust than they receive when they sell them—a difference that can vary and goes to the trust management as a profit.
Oeics have a single price for both purchase and sale of units (so no bid-offer spread), making them similar to collective funds marketed to investors in Europe and the US.
Investment trust funds
The oldest fund type is called an investment trust. These are listed as investment companies on the London Stock Exchange. Investors then buy and sell shares in the investment trust on the stock market.
Investment trusts pool money from investors to buy a variety of investments such as shares, bonds, gold or property. They then aim to generate growth or income or a combination of both on behalf of their shareholders, the investors. An active professional fund manager is in charge of running the trust, making active decisions about the underlying investments.
There are more than 400 investment trusts that invest in everything from global equities, to specialist investments such as renewable infrastructure, commercial property and private equity (investments in private companies that aren’t listed on stock exchanges).
A key attraction of investment trusts is their potential to provide a consistent income to investors. Unlike other types of funds, investment trusts can retain 15% of their net income each year. This means when their investments pay good dividends they can retain some of them to pay out more to investors in bad years for dividends. That means many of the income-paying investment trusts are still very popular with investors today.
Another advantage of investment trusts are the independent boards overseeing the fund, who are tasked to protect shareholder’s interests and make sure the fund is managed well.
There’s a fixed number of shares available to buy or sell, which means they are ‘closed-ended’. The fund manager always knows what money he or she has available to invest, which can be an advantage.
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Investment trust gearing, discounts and premiums explained
Some people find the structure of an investment trust tricky to understand. For example, an investment trust can borrow to invest more money. This is called ‘gearing’ and can make the trust grow faster but can also harm investment performance if the fund manager makes the wrong call.
An investment trust can also trade at a discount or a premium to the value of the underlying investments (or assets) that it holds.
The discount or premium is the gap between the share price and the value of assets held by the investment trust. So if an investment trust has 100p of assets per share and a share price of 90p, it’s trading at a 10% discount. But if the same investment trust has a share price of 110p, it’s trading at a premium.
This matters because it can affect the return you get as a shareholder.
If a discount doesn’t change during the time you hold an investment trust, it makes no difference.
But let’s imagine that you invest in this trust on a 10% discount, and sell it when the discount has narrowed to 5%t. So, you invested at a share price of 90p, but sold your shares at 104.5p. The narrowing of the discount has transformed a 10 per cent return on the trust’s portfolio to a 16.1% share price return (the return you actually get). Great!
Of course, this can work the other way round. Let’s say you bought on a 5% discount but this widened to a 10% discount, when you had to sell the trust. Now your share price return is only 4.2%, less than the underlying portfolio return of 10%. Not great!
What’s the best fund?
Does it matter what type of fund you pick to get started? Probably not.
ETFs and many passive funds are good for keeping your costs low, and are good options for beginners.
Meanwhile, in general, investment trusts are good for illiquid assets (such as private equity and commercial property) that can’t be bought or sold easily, because of their closed ended nature. The key thing is to get started and benefit from the compounding of investment returns over time.