Investment funds pool together money from many people to invest in a wide range of assets. This method makes it easier for individuals to own a diverse portfolio, which could be hard to achieve on their own. Managed by experts, these funds aim to grow the investors' money and generate income. The idea of combining resources for investment isn't new – it dates back to the 18th century in the Netherlands. Since then, as financial markets around the world have grown, so have investment funds, especially after World War II. Today, they are a key part of financial planning and wealth management, offering access to different kinds of assets like stocks, bonds, real estate and commodities. Funds fit various investment strategies and risk levels, appealing to a broad range of investors.
TYPES OF FUNDS EXPLAINED
Unit trusts: These are popular in the UK for pooling money into a single fund, mainly investing in stocks and bonds. The investment is divided into units and their value changes based on how well the fund performs. Unit trusts are easy to understand and offer flexibility, allowing investors to add or withdraw money relatively easily.
Open-ended investment companies (OEICs): Similar to unit trusts, OEICs also pool money from investors but are structured as companies. This structure lets them adjust the size of the fund by creating or cancelling shares, making it easier to manage changes in investor numbers. OEICs invest in a variety of assets and are valued directly by the performance of these assets, known for their liquidity and diverse investment opportunities.
Investment trusts: These are closed-ended, meaning they have a set number of shares and are listed on stock exchanges. They can take a longer-term view on investments and have the ability to borrow money to invest, potentially increasing returns but also adding more risk. Investment trusts may trade at a discount or premium to the actual value of their assets.
Exchange-traded funds (ETFs): ETFs are becoming increasingly popular because they combine features of mutual funds and stocks. They are traded on stock exchanges and can be bought and sold throughout the trading day, offering real-time pricing and high liquidity. Mostly, ETFs track an index, offering a passive investment strategy that often leads to lower fees.
Venture capital trusts (VCTs): VCTs are designed to invest in small, high-growth potential companies. They offer significant tax reliefs to investors, making them attractive for tax-efficient investing, but come with higher risk due to the nature of the companies they invest in.
Hedge funds: These are complex investment vehicles meant for wealthy or institutional investors. They use diverse strategies, including betting on stocks going up or down, using derivatives and leveraging to aim for high returns regardless of market direction. Hedge funds are known for their high-risk, high-reward profile and usually require significant minimum investments.
HOW FUNDS OPERATE
Funds work by gathering money from many investors, allowing them to take part in opportunities that would be otherwise unreachable. The pooled capital enables the fund to invest in a wide variety of assets, helping to spread out risk. The heart of a fund's operation is its management – professional managers decide where to invest to meet the fund's objectives, such as capital growth, income generation or capital preservation. These managers use their expertise to pick investments they believe will succeed, adjusting the fund's holdings based on market trends and economic indicators.
ACTIVE VS PASSIVE MANAGEMENT
The distinction between active and passive management marks a significant choice for investors, reflecting different strategies and objectives.
Active management: Here, fund managers actively pick stocks, bonds or other assets in an attempt to outperform the market. This approach relies on thorough research, market analysis and the managers' judgment to make timely investment decisions. Although active management can offer the potential for higher returns, it generally incurs higher fees due to the involved active trading and research efforts.
Passive management: Passive funds aim to replicate the performance of a specific index, such as the FTSE 100 or the S&P 500, thereby mirroring the market's returns. This strategy benefits from lower management fees, as it involves less frequent trading and decision-making. Investors who prefer passive management believe in the efficiency of markets and the challenge of consistently beating the market through active management.
INVESTING IN FUNDS: PROS AND CONS
Funds offer diversification, professional management and ease of investment, making them accessible to those with limited capital:
Diversification: Funds can diversify across different assets, sectors and regions, reducing risk.
Professional management: Expert fund managers and research teams work to make informed investment decisions on behalf of investors.
Accessibility: Funds offer a convenient way to invest in a broad range of assets, even for those with limited capital.
However, like all investments, they carry risks – market fluctuations, management decisions and costs can affect returns. Understanding these risks and benefits is crucial for investors to make choices that align with their financial goals and risk tolerance.
Market risk: The possibility of losses due to overall market declines.
Management risk: The risk that the fund manager's investment choices do not perform as expected.
Costs: Fees and other expenses can eat into investment returns, especially in actively managed funds.
Liquidity risk: Some funds, particularly those investing in less liquid markets or with withdrawal restrictions, may make it difficult to access funds when needed.
EVALUATING FUND PERFORMANCE
To make informed investment choices, consider several factors when evaluating and comparing funds.
Performance history: Examine long-term performance, as short-term results can be misleading.
Risk-adjusted returns: Assess returns relative to the amount of risk taken, offering a more comprehensive view of performance.
Fund management: The fund manager's experience and track record can indicate the fund's potential success.
Investment strategy: Understanding how the fund intends to achieve its objectives can provide insights into future performance prospects.
THE IMPACT OF FEES AND EXPENSES
Fees significantly influence investment returns over time. Actively managed funds, with their higher research and trading costs, usually charge more than passive funds. Investors should carefully consider these fees in the context of expected returns and their investment goals.
DIVERSITY IN INVESTMENT CHOICES
Funds offer a variety of investment options across different asset classes, each with unique characteristics, benefits and risks.
Equity funds: Invest in stocks of companies. They aim for capital growth but come with higher volatility. Equity funds can focus on specific sectors, regions or investment styles (e.g., value or growth).
Bond funds: These funds invest in debt securities, offering regular income and lower risk compared to equity funds. They can vary based on the type of issuers (government, corporate) and maturity periods (short, medium, long term).
Property funds: Invest in real estate assets or real estate investment trusts (REITs), aiming to generate income through rent and capital appreciation. Property funds can offer diversification benefits but may have higher liquidity risk.
Alternatives funds: Include investments in assets other than stocks and bonds, such as commodities, private equity or hedge funds strategies. They aim to provide diversification and reduce volatility but can be more complex and less transparent.
Multi-asset funds: Allocate investments across several asset classes, including stocks, bonds and sometimes alternatives, to balance risk and return. They offer built-in diversification and can adjust asset allocation in response to market changes.
Funds of funds: Invest in a collection of other funds rather than direct securities. This adds another layer of diversification, though it may result in higher total fees due to costs at both the fund-of-funds and the underlying fund levels.
Absolute return funds: Aim to generate positive returns under all market conditions using various strategies, including leverage, derivatives and short selling. While they seek to minimise risk and volatility, their complex strategies and higher fees require careful consideration.
Each type of fund caters to different investor goals, risk tolerances and market views. By understanding the diverse range of investment options available, investors can better align their choices with their financial objectives and investment strategy.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.