Most people who invest for the long term using individual savings accounts (Isas) choose collective investment funds as part of their portfolio. The main advantage of funds is that your investment is pooled with other investors' money and is used to buy exposure to a much wider range of stocks and shares than you would be able to achieve on your own.
Access many assets
Funds are sometimes also the only way to invest in certain far-flung stock markets that it would be very hard to access under your own steam, particularly emerging markets such as Brazil or Vietnam. But funds are not restricted to investing in equities. They can give you exposure to asset classes such as corporate bonds, commercial property, commodities, hedge funds and private equity.
Picking funds for your Isa can be as easy or as complex as you like. You could, for example, simply stick the whole lot in a UK FTSE All-Share tracker fund and then sit back and hope for the best. But, ideally, you should put as much time and effort into making your choice of fund as you would when selecting a portfolio of individual equities.
Which fund type
There are many factors to consider when deciding between funds, from the structure of the fund, to the calibre of the fund manager, to the investment strategy and the assets that it holds.
You're spoilt for choice, as there are around 2,000 open-ended funds to choose from, plus a few hundred investment trusts. Most investors choose open-ended funds. That's firstly because there are more of them, and secondly because they are more heavily advertised and marketed than investment trusts. Open-ended funds are the ones you'll see advertised on billboards around the country over the next few months.
Unit trusts
Open-ended funds get bigger as more people invest and smaller as investors withdraw their money. They fall into two types – unit trusts and open-ended investment companies (Oeics). A unit trust is made up of many individual pieces called units, which investors buy to hold a stake in the fund. The price of a unit is based on the value of the fund's assets. Unit trusts have two prices – the offer price, which you pay to buy units, and the bid price, which you get for selling units. The offer price is higher than the bid price and the fund manager pockets the difference.
Oeics
Oeics are similar to unit trusts but package their investments into shares rather than units. The number of shares issued rises and falls as shares are bought and sold. Oeic shares have a single price.
Investment trusts
Investment trusts are closed-ended funds – there is a set number of shares that does not change regardless of how many investors there are. When you invest in an investment trust, you are buying shares in a company that invests in other securities, rather than buying units in a fund. However, investment trusts are more complex, higher-risk investment vehicles than open-ended funds. Investment trust shares frequently trade at a discount or a premium to the value of the underlying assets. So you might easily end up paying 90p or £1.10 for assets worth £1. This exaggerates the pattern of share price performance both upwards and downwards compared with returns from open-ended vehicles.
Investment trusts can also borrow money to invest, a process known as gearing. An investment trust that is geared is a riskier investment than one that is not geared, because just as the borrowings can magnify the gains, they can cause any losses to be much greater.
In the long term, being closed-ended can be advantageous for the investment trust manager, as it means they don't have to sell shares in the trust that they would rather keep when investors want to cash in their investments.
Don't get too distracted by the structure of a fund, though. Whether it is open- or closed-ended is not nearly as important as what its holdings and investment strategy are. If you already have an investment portfolio, you need to find funds to complement your existing holdings.
Look overseas for profit
British investors are generally too concentrated in UK shares. If you already have a big chunk of your wealth in shares, perhaps through your pension or another holding, you should look at diversifying by holding an overseas equities fund and perhaps an emerging markets fund. A corporate bond fund could also help reduce the overall risk profile of your portfolio.
Don't be a fashion victim
Never make the mistake of chasing fashionable funds blindly. Investors who piled into technology funds in 2000 or commercial property funds in late 2006 got their fingers badly burned. In the past couple of years, we have seen a few investment fund launches in areas that should not be considered core holdings for a portfolio – agricultural commodities, Middle East and Africa funds, and climate change funds, for example.
These are fine if you already have a substantial portfolio and have some money available to play with or to dabble in unusual areas. For most investors, though, funds investing in the core assets of bonds and equities, and perhaps commercial property and gold, should be more than enough to construct a diversified portfolio. You can even find funds that do this for you. Balanced managed funds, for example, will invest in a range of assets, offering a ready-made diversified portfolio.
How to judge fund managers
The regulator says that past performance is not a guide to future performance, but for many investors it's the first thing that they look at. It's only natural to want to know that the fund manager has done well over a reasonable period of time.
Make sure, however, that the same fund manager is responsible for the investment performance. Fund managers move around often and investors should beware – they may be looking at a 'ghost performance' achieved by long-departed managers.
If you do choose a fund based on manager reputation and performance you may be faced with the dilemma of what to do when he or she moves on to manage another fund.
Cost control
It's really important to look at the charges on a fund, too – not just the annual management charge but something called the total expense ratio (TER), which takes into account all expenses incurred in the fund. The average TER for an actively managed fund is about 1.5 per cent. If a fund charges more than this, question if you are really getting added value for the extra fee. See our article on keeping costs down.
Regular savings vs lump sums Many investors put a lump sum into an Isa – either at the end of the tax year when they know how much they have available to save, or when they think they will benefit from market conditions. This is not the best strategy, though, as the odds of getting your timing right are slim. It is much better to commit money to an Isa on a regular and consistent basis. This will remove any need for you to make market-timing decisions, and it will also enable you to benefit from 'pound-cost averaging'. If you're investing the same amount into a fund every month, you are automatically buying more units or shares in the fund when prices are low and fewer when prices are high. The effect of pound-cost averaging is that you buy at a lower overall cost than the actual average price over the same period. Imagine a year in which the market fluctuates around its starting point, ending up with very little increase. In such a year a regular savings plan should beat the same money invested as a lump sum at the start of the year. |
