Investment funds

Managing and reducing risk is a constant part of any investment strategy – and it’s one we ignore at our peril. Although it may sometimes be tempting to invest everything in one ‘promising’ opportunity, the risk is that if it fails you lose everything. ‘Not putting all your eggs in one basket’ is an essential maxim to remember – rather than invest in just one or two opportunities, we should consciously work towards building a ‘diverse portfolio’, spreading our capital, and the associated risk, across different types of investment.

But that often brings a problem. Although we may have a good understanding about one or two companies, our knowledge may be dangerously imperfect when it comes to ten or twenty. We could go ahead and invest in other companies, but doing so may be tantamount to playing ‘Russian roulette’ with our money; we may be making little more than a random selection and, inadvertently, introducing further risks into an already risky environment. The ‘million-dollar question’ is, of course: How do we know which are the best companies to invest in and, more appropriately, which are the ones most likely to yield the best return on our investment?

Fortunately, there’s an easy option: investment funds. Investment funds are ready-made portfolios; unique collections of assets that offer a practical and easy way to spread our investment capital without having to do lots of research. Funds are ‘collective schemes’, and the three most common types in the UK are ‘unit trusts’, ‘open-ended investment companies’ (OEICs) and ‘exchange traded funds’ (ETFs). Historically, funds were predominantly ‘actively managed’ but, for reasons including better computing ability and lower costs, the number of ‘passively managed’ funds has increased over recent years. Currently, the Investment Association lists over 2,000 actively managed funds investing in over 30 sectors; conversely, there are fewer than 100 passively managed funds, but the balance is changing.

Actively managed vs passively managed investment funds

Actively managed funds are managed by a professional fund manager who is responsible for the fund’s performance. The fund manager selects the individual companies listed by the fund and then monitors and analyses their performance against market conditions, using their knowledge and expertise to decide whether shares of any particular company within the fund should be bought or sold.

Actively managed funds aim to deliver a return above that of a ‘benchmark’ fund, for example, the FTSE All-Share Index, and, providing the fund manager makes the right decisions at the right time, aims to give a higher return than a similar passively managed fund.

Having someone constantly monitoring and managing the fund is, of course, an advantage – but it can also be a disadvantage. Fund managers are expensive and their provision is reflected in the fees the fund charges; it means that an actively managed fund has to be more successful than an equivalent passively managed fund as the return has to cover the cost of the fund manager. Unfortunately, the reality is that only a quarter of actively managed funds exceeded the performance of their target benchmark fund during the period 2000 to 2010.

Passively managed funds also have potentially serious disadvantages. If the fund is dominated by a particular sector, a problem within that sector can cause the entire index to deteriorate, taking the fund with it. In addition, the lack of a fund manager can mean the fund doesn’t have the ability to either foresee or quickly react to events as they unfold. A prime example of these two shortcomings was the banking crisis of 2008 – at the time, the FTSE 100 was dominated by one sector, banks, and the lack of a fund manager meant that many funds didn’t have the ability to react to a sudden collapse in the market.

Unit trust

A unit trust is a collective, open-ended investment fund formed under a business trust deed.

The fund is divided into equal ‘units’, the price of each unit being based on the fund’s net asset value (NAV). The NAV is calculated on a daily basis meaning its value reflects the value of the investment and is not affected by demand for the units themselves. The number of units is infinite; when either new or existing investors want to invest more money, more units are created to satisfy demand for them.

The money paid by individual investors buying units is collected into a single, actively managed fund by a fund manager who then invests it in ‘securities’, the term used for the type of financial instruments a unit trust can hold, for example, shares, bonds and gilts.

Open-ended investment companies (OEICs)

OEICs work in a similar way to unit trusts except that the fund is set up as a company rather than as a business trust so it deals in shares rather than in units. Each share has a single purchase and sale price but its value still reflects the value of the assets the fund manager has invested in.

Exchange traded funds (ETFs)

ETFs, often known as ‘tracker’ or ‘index’ funds, simply follow the movement of an existing stock market index such as the FTSE 100, FTSE 250 or FTSE All-Share. As fund management isn’t provided they’re termed ‘passively managed’ investment funds.

A stock market index consists of a selection of stocks and shares, for example, the FTSE 100 is an index that represents the 100 largest companies in the UK, and the FTSE All-Share represents all companies listed on the London Stock Exchange. Tracker funds ‘track’ the movement of the index they follow by either fully or partially replicating it. If the fund uses full replication it buys a proportionate number of shares in all the companies listed by the index, which means the performance of the fund exactly mirrors the performance of the index. However, full replication can become impractical as the number of shares listed by an index rises: buying shares in the 100 companies listed on the FTSE 100 is a practical proposition whereas buying shares in the 600+ companies listed by the FTSE All-Share index is neither practical nor desirable.

The simplicity of tracker-style funds makes them unsuitable for some asset classes, a typical example being property where returns are based on buying and selling property and the rental income that results from it.

Investment trusts

Unlike an investment fund, an investment trust is formed and listed as a company so investors buy shares in the company rather than investing in a fund. The number of shares available is limited: investment trusts are referred to as being ‘closed-ended’ whereas investment funds, with no limit to the number of units they can issue, are termed ‘open-ended’ funds.

The price of the shares can be affected by both the performance of the underlying investment and by ‘investor sentiment’, a subjective feeling about a particular company, which often results from how its performance in the ‘real world’ will affect its share price. With a finite number of shares being available, the share price of an investment trust is subject to supply and demand: if demand for a particular share increases then the share price will rise, but if shareholders start to sell their shares, their price will fall.

As a result, investment trusts can trade at either a premium (above) or at a discount (below) to the value of the underlying assets. Buying shares at a 10% premium means you are paying 10% more than the value per share of the assets the trust is invested in: if the premium started to fall you would probably lose money. Conversely, investment trusts can be bought at a discount enabling you to buy shares at less than the value of the assets. If the investment trust performed well, and attracted more investors, demand for shares would then increase, as would their value. The current premium or discount price of investment trust shares are quoted on most stockbroker websites.

Historically, investment trusts were generally considered to have lower management fees than open-ended funds, however, recent FCA regulatory changes have reduced the fees charged by open-ended funds, reducing the differential between the two.

Investment bonds

An investment bond is a (single-premium) life insurance policy. You invest a lump sum (the single premium) and, when the bond is surrendered, you receive a lump sum back. The minimum investment is usually between £5,000 and £10,000 and most bonds are taken on a ‘whole of life’ basis, ie: the intention being that they are surrendered when you, the investor, die.

The lump sum is invested, usually in a range of shares and funds, and any returns are either added to the initial investment or paid to you as income. Two types of fund are available – ‘with-profits’ or ‘unit-linked’ – but the most important point is to choose a bond that allows you to invest in a variety of funds and to switch between them as this offers the opportunity to iron out the inevitable peaks and troughs that occur over the long term.

The bond’s terms and conditions are important. Some may protect, or even guarantee, your capital, ie: that what you get back when you surrender the bond will be at least equal to what you originally invested, but this usually involves a ‘counterparty’ which brings an additional level of risk. As it’s a life insurance policy there’s usually a specific payout in the event of your death, for example 101% of the value of your bond, but the figure may be higher for accidental death.

Investment bonds usually allow you to make regular withdrawals each year up to a specified limit and, although you are free to withdraw more than this figure, even to the extent of surrendering the bond, you need to be wary of any surrender penalties that may apply, in particular during the first few years.

Investment bonds can be set up to meet an individual investor’s needs; most insurers market a range of bonds that offer different features and benefits. Choosing a bond that protects your money means that you may not lose money, and having the facility to switch between the insurer’s investment funds and waiving early-surrender fees may attract additional fees but could be worth the premium.

Multi-manager investment

The success of any actively managed fund is determined by the knowledge and expertise of the person managing it, the fund manager. However, fund managers cannot be expected to be experts across all asset classes and usually have a tendency to specialise in what they know best, which inevitably affects the fund’s diversity and balance.

Multi-manager investments mitigate this by using a team of fund managers – either directly or indirectly – with each specialising in a specific asset class, the premise being that a group of specialists will be more successful than an individual.

The two most common multi-manager approaches are ‘manager of manager’ (direct) and ‘fund of funds’ (indirect).

A manager of manager fund (MOM) uses a team of fund managers rather than a single fund manager, each having responsibility for a single asset class with which they have particular expertise. Therefore, a fund could have several fund managers each working independently with direct access to buying and selling, but only within the asset class they are responsible for.

A fund of funds (FOF) invests in other funds either on a ‘fettered’ basis, where the fund invests in funds managed by the same institution, or ‘unfettered’, where the fund invests in funds managed by other institutions. A fund of funds relies on the knowledge and expertise of fund managers managing their own funds and cannot buy and sell securities within the asset classes the fund has invested in.

Multi-asset investment funds

Although investing in a fund helps to create a diverse portfolio, funds can be quite focused. They may concentrate on a specific stock market, asset class or market sector; they may track the FTSE 100, be invested solely in equities or, within that, just one sector, construction, for example.

Multi-asset investment funds address this by, as their name suggests, spreading their investment across a range of asset classes, investing in cash, bonds, property, equities and alternatives, maximising the diversity of their investors’ portfolios and using their characteristics to help even out the peaks and troughs that would probably occur if just one asset class was invested in.

Although investment should be considered on a long-term basis, some funds use ‘absolute return strategies’ in an effort to achieve a worthwhile performance in the short term, typically within a year. To do so, absolute return portfolios invest across a wide range of asset classes and geographies to spread the risk and then use advanced investment strategies to try to reach their objectives.

Fund charges

In 2013, the Financial Conduct Authority (FCA) introduced new rules governing investment fund fees. The move specifically banned the payment of commission to financial advisers which significantly reduced the scale of the fee investors were charged.

Most investment fund providers scrapped the initial charge for joining the fund and reduced their ongoing charges by around 50%.  Typically, the annual management charge (AMC) levied on an actively managed fund is now about 0.85%, the addition of expenses increasing this to around 1.0%, the total ongoing charge fee (OCF).

Passively managed funds have remained much cheaper in most cases, with some now charging less than 0.1% in ongoing fees, around 0.75% less expensive than a similar actively managed fund.

Receiving a return

If the fund you’ve invested in grows, then you receive a return which is called a ‘distribution’ and derives from either dividend payments the fund receives from the shares it’s invested in, interest payments from bonds or rental income from property investments.

The distribution may be monthly, quarterly, half-yearly or annually, depending on the type of fund you’ve invested in. Most unit trusts and OEICs will allow you to take either income or reinvest the distribution in the fund (‘accumulate’), increasing the capital value of your investment.

Stocks and Shares ISAs

Many types of investment, including unit trusts, OEICs, ETFs, investment trusts, equities and investment bonds, can be held in Stocks and Shares ISAs which protects any return on your investment from tax.

Although limited by the £20,000 annual ISA allowance (tax year 2023-24) – which limits how much of your investment can be transferred into your ISA each year – holding your investments in a tax wrapper can only be a good thing. Investments that pay interest or rental income will provide tax-free income if they’re held within an ISA; dividends received from funds or shares will remain tax free and any profit you may make from selling your investments is free of Capital Gains Tax.
 

How can One Financial Solutions help you?

“It’s not about timing the market, it’s time IN the market that counts.” is another of Warren Buffet’s legendary quotes. Apart from re-emphasising that investment should be treated as a long-term venture, it also underlines that ‘being in the market’ helps build the all-important store of knowledge and experience you need to be successful – something you can’t pick-up quickly.

One Financial Solutions is here to help you. Our advisers are experts who live and breathe investment – it’s how they make their living. They’ll take time to talk to you about your financial objectives, the level of risk you’re prepared to accept and any investment preferences you may have. They’ll provide expert guidance and, once you’re happy to go ahead, they’ll put everything in place and keep you updated for the duration of your investment.

So, if you’re looking for help with any aspect of investment, please call us on 020 3714 9565 or ask us to call you by sending an email to admin@onefinancialsolutions.co.uk.