We've dealt with the difference between active and passive management, and the pros and cons of each, in a separate article. We also have a whole investment guide devoted to exchange traded funds (ETFs). This article runs through other types of funds:
Guaranteed funds
Guaranteed funds, sometimes called "protected" funds, promise to return some or all of the capital invested, usually as long as certain criteria are met. For example, the original investment is returned if a set of shares, an index or a combination of share indices reaches a particular level over a certain period.
They can also promise a specified return at a specified time. The guarantee is usually met through the use of financial instruments, such as options, which offer the potential to protect the overall investment. To pay for the guarantee, investors agree to a cap on the amount they receive in the event of equity markets rising. This means it is unlikely that guaranteed funds will grow as fast as non-guaranteed funds when the stock market is performing well.
Guaranteed funds have a set life, and are a type of structured product, although not all structured products are guaranteed. An example of a guaranteed product is a guaranteed income bond, where an investor buys a single-premium bond from a life assurance company. The bond has a fixed term, and the investor is promised a return of capital at a pre-determined date in the future plus, over the term, a pre-determined amount of income on specific dates.
An example of a guaranteed fund that invests in the equity market is one that offers a fixed-term investment based on a particular stock market index, at the end of which time the original capital is returned regardless of what has happened to the market over the period. Any additional return will depend on the index's performance.
Some structured products, such as so-called "precipice bonds", do not offer a guaranteed return of the capital invested.
With-profit funds
With-profits funds are smoothed investments run by life assurers, which aim to smooth out markets volatility by holding back some returns made when markets rise and topping up holdings when they fall.
Millions of people use the funds to build up pensions or repay mortgages. Their asset allocation varies, with the proportion of assets held in shares ranging from zero to 75 per cent, according to Ned Cazalet, the respected insurance analyst. The rest is largely in bonds and cash, while some companies invest in commercial property.
For a conventional with-profits policy, the payout is typically made up of the basic sum assured, the annual bonus, which cannot be taken away unless you cash in early, or during adverse stock market conditions. Part of the payout also comes from the terminal bonus, which is not guaranteed and will not be known until the policy proceeds become payable when the investment matures. There is no price that investors can check to see how the fund is doing.
A recent briefing note by the Institute of Actuaries warned that payouts would continue to fall, partly because the outlook for future returns remained lower. To protect investments, it seemed likely that companies would cut pay outs faster than had been normal.
Unit-linked funds
Unit-linked funds are managed by life assurance companies. Unlike with-profits funds, they do not normally have "smoothing" - the process of holding back some returns made when markets rise and topping up investments when they fall. If the market falls by 10 per cent, investors holdings in unit-linked funds usually drop by 10 per cent.
The funds invest in a range of asset classes, including equities, bonds, and property. The amount invested in shares varies, ranging from a maximum 35 per cent in the "defensive managed" sector to 100 per cent in the "stock market managed" sector.
Currency exposure also varies. The defensive managed sector requires funds to have at least 85 per cent of assets in sterling-denominated investments, while the stock market managed sector asks for only 50 per cent.
Investors can usually check the funds prices daily, although pricing is more infrequent for property funds.
Unit-linked funds are the vehicles into which investors money is likely to go if they buy unsmoothed pensions or other investments from life assurance companies. Charges vary among different products.
Hedge funds
Hedge funds can put investors money in a range of assets including equities and bonds. Like conventional funds, they can buy shares or fixed income securities in the hope of selling at a higher price. But unlike most normal funds, hedge funds can sell securities they have borrowed, in the hope of returning them to the lender, while keeping the profit. The basket of shares which has been "sold short" in this way is the insurance, or hedge, against a fall in the market.
Another distinctive feature of hedge funds is their ability to borrow and invest the proceeds. They can also charge performance-based fees. Hedge funds are not yet authorised in the UK, and if the funds collapse, investors are unlikely to be entitled to compensation.
Investment strategies vary but macro hedge funds can take bets on currencies, depending on their managers views about the relevant economies prospects. Equity market neutral funds will buy shares in one company that they think is cheap, while matching their exposure by selling shares in another company that they think is expensive.
Investors should note that performance figures for hedge funds as a whole can be misleading because they relate to hedge funds which are closed to new investors.
Sectoral funds
Sectoral funds put investors money in companies which belong to specific industries, such as technology. They sprang to prominence towards the end of the bull market as asset management groups launched numerous funds, many investing in technology companies.
Advocates of the funds could argue that they give investors exposure to sectors that are under-represented in their portfolios. However, one danger is that investors who buy sectoral funds concentrate their risk, instead of diversifying it. If shares in the relevant industry's companies fall, the money invested in the sectoral fund would drop.
Investors might prefer to get exposure to sectors by picking broadly-based funds. A UK fund would be likely to include banks, oil companies, drug groups and telecoms operators. The costs of sectoral funds are sometimes higher than fees for broadly based funds.
Corporate bond funds
UK corporate bond funds invest at least 80 per cent of investors money in sterling-denominated bonds issued by companies with a credit rating of triple B or above. That means the businesses must be judged to be investment grade, according to credit rating agencies such as Standard & Poor's, whose ratings of creditworthiness range from AAA, the highest, to D, the lowest.
Some of the biggest funds hold bonds issued by more than 100 companies, which reduces the potential loss to investors if an individual company fails to pay interest or repay capital. Rising interest rates will make the fixed income offered by bonds less valuable, relative to other investments, and that will reduce the bonds prices, exposing investors to the risk of a capital loss.
The fall in prices, does, however, make buying bonds cheaper, and raises the yield - the fixed interest as a proportion of the price. That makes bonds more attractive to new investors, providing a market for holders who wish to sell.
International funds
International funds put investors money into companies based in specific geographical areas, such as Europe or North America. To qualify for a given region, funds must invest at least 80 per cent of assets in a specified region.
International equity funds tend not to hedge their currency exposure, so they are unlikely to be appropriate for investors who cannot afford to take foreign exchange risk. If the currency markets moved against them during the period in which they invested, they could lose out. Such investors might believe that they should have their assets denominated in the same currency as their liabilities.
People who are sceptical about the need to buy international funds would argue that investors can get exposure to international economies by investing in UK funds, which buy shares in British companies that trade worldwide. Against that, others would argue that investing internationally enables people to diversify their portfolios. If one market falls, investors losses might be offset by gains made elsewhere.
There is a sectoral issue - investors who keep their money in the UK would struggle to get significant exposure to the automotive sector. By investing overseas, they could potentially benefit from any increase in, for example, carmakers share prices.
Equity income funds
These are funds whose managers aim to put investors money into cheap companies with low price/earnings ratios. While all fund managers hunt undervalued businesses, value funds are also associated with companies that have high dividend yields. Such funds invest at least 80 per cent of investors money in British shares and aim to have a yield equivalent to at least 110 per cent of the FTSE All-Share index.
Smaller company funds
Smaller companies funds put at least 80 per cent of investors money into UK shares issued by companies in the Hoare Govett smaller companies index, which aims to capture the smallest 10 per cent of the market in value.
