If you’re about to enter the investment world, it’s important to know where your money will be going. In other words, what will you be investing in? With plenty of investments available, building a plan can be quite overwhelming, and if you want to make the right decision, it could be wise to familiarise yourself with each asset type. Whilst it’s quite common to hear people talking about shares and bonds, investment funds aren’t talked about quite so much. So, what are they? And are they right for you? Here’s a short guide to help you understand how investment funds work.
What are investment funds?
Put very simply, investment funds are like hampers full of investments. So, by investing in a single fund, you could well be holding hundreds, or even thousands of individual investments, which is a very useful way of spreading the risk or diversifying your investment plan. Funds are typically managed by professionals and these experts are commonly known as ‘fund managers.’ Their job is to manage the fund in line with the fund objectives, whether that is to replicate the performance of an index like the FTSE 100, the 100 largest companies listed on the London Stock Exchange, or to maximise returns with a sustainable focus - the active funds we use in our ethical plans for example. In return, you need to pay an annual fee, also called fund charge, to the fund provider.
Funds come in all shapes and sizes. Some will contain one type of investment from one particular place, whilst others will include a mix of asset types coming from different regions. For instance, a fund could choose to only invest in the UK’s main stock market, the FTSE 100. Meanwhile, another fund could include shares and bonds from different markets. As an investor, it’s important to look at what’s in the fund, otherwise you could be putting your money in things that don’t necessarily match your investment style.
Most funds are divided into units and you should be able to buy some of these units. By purchasing a unit, you’ll own a part of the fund and depending on what you’ve bought, you could be holding a plethora of investments. And that’s the great thing about funds! They allow you to build a well-balanced, diversified portfolio without the hassle of having to pick each individual investment yourself. In other words, they’re a good, effortless way to spread your money across investment types and regions.
What are the different types of funds?
Needless to say, investment funds don’t form a homogenous group. If you’re just getting started, you’ll quickly find out that there are multiple types of funds available, and they all have their own characteristics. So, if you want to maximise your investment journey, it’s usually a good idea to do some research and get to know the different kinds of funds you can invest in.
Active vs passive
Let’s start with active and passive funds. Actively managed funds are designed to beat the market and provide investors with higher returns. Fund managers will pick investments they think could outperform the fund’s benchmark – they spend a considerable amount of time analysing market data and researching potential winners on your behalf.
On paper this is very appealing, but it isn’t without risks as beating the market is no easy task, even for investment experts! There is a chance that your fund manager won’t manage to deliver the stellar returns they may have forecasted. But this isn’t the only reason for choosing this type of fund. Investing in active funds means that you have someone picking and managing your investments, which means that if you’re an ethical investor, someone is carefully monitoring each investment’s credibility to ensure it fits in your fund – we’ll go into this a bit more later. This does mean that active fund charges could be a bit higher depending on the provider you’re using. So, before you commit, make sure you’re comfortable paying a bit more to benefit from such expertise.
Active investing isn’t the only route you can take. If you’re not convinced by active funds, why not have a look at passive funds instead? Rather than trying to find winners, passive funds are designed to mirror the collective returns of the market, minus a small fee. Put simply, they will track a specific benchmark index, such as the FTSE 100 or the S&P 500, also known as tracker funds. The performance of the passive funds investment will depend on how well the benchmark indices are doing. Say you invest in a fund tracking the FTSE 100. Your returns will follow the performance of the UK market. So, if the FTSE 100 goes down 10%, then your investment will likely fall at a similar pace, and vice versa, if the market goes up 10%, you could expect your investments to increase about 10%. What’s more, passive funds tend to be cheaper compared to active funds – this is because you already know what the fund needs to hold so you don’t need as many analysts.
Both active and passive funds have their pros and cons, and at the end of the day, the choice is completely up to you. With active funds, you get an expert who works hard to try and beat the market. But there’s no guarantee it will work, and it can be more expensive. On the other hand, with passive funds, your returns will simply follow the performance of the market in exchange for a low fee. This means you’ll need to learn to live with market movements, and you may want to remain focused on your long-term goals.
Mutual funds vs ETFs
The most common types of investment funds are mutual funds and ETFs (Exchange-Traded Funds). So, what exactly are they and how do they work? Think of mutual funds like a collection of individual investments – a bit like a portfolio, but instead of buying all the underlying assets, you can buy one unit of the fund. Mutual funds, also known as OEICs (open-ended investment companies) and unit trusts, have existed for a very long time. In fact, the first mutual fund, Massachusetts Investors Trust, was created in March 1924, almost a century ago! The main particularity of mutual funds is that they can’t be traded on the stock market. To invest in a mutual fund, you’ll need to send an order instruction to the fund administrator via a fund supermarket platform online or other places. This also means that mutual funds are only priced once a day, typically at 12pm from Monday to Friday in the UK – in the investment world, we commonly talk about single pricing point or NAV (net asset value). If you miss the cut-off time for a day, you’ll have to wait until the following day to place your trades.
Then you’ve got ETFs. These are very similar to mutual funds in terms of owning a group of investments. But unlike mutual funds which can only be bought or sold once a day, ETFs can be traded on the stock markets at any point of the day during trading hours – in the UK, stock markets are open 8.00am to 4.30pm, Monday to Friday, excluding bank and national holidays. This means you can take advantage of price fluctuations and trade lots of investments all at once.
Income vs accumulation
Investment funds typically come in two variants, income and accumulation funds. As the name implies, income funds will provide you with an income. By this, we mean that you’ll receive a dividend payment from the fund provider if you’re investing in a fund of shares, or an interest or coupon payment if you’re investing in a fund made up of bonds. The frequency of these payments can vary from quarterly, semi-annually, annually or with no regular defined periods. .With income funds, you will typically receive a cash payment which can either be paid into your bank account, or at Wealthify, we will reinvest any dividend or interest payments received back into your chosen investment style.
Alternatively, accumulation funds are all about growth, not income. Instead of the fund provider paying you dividends and interest, they will reinvest all your earnings back into the fund, which could help boost your pot. By having everything reinvested and assuming your investments are doing well, your profits would generate further profits and over time, your money could snowball – that’s what we call compounding. At Wealthify, our focus is to provide you with long-term growth, so we make sure to use accumulation funds to build our portfolios, although we’ll occasionally use income funds as well.
Now let’s tackle ethical investment funds! Investing is evolving and it’s now possible, and increasingly popular, to invest ethically. This type of investing is about maximising your potential profits whilst supporting companies committed to driving positive change in society. And a good way to invest ethically is to purchase ethical funds. Most funds will exclude activities that are considered harmful to the environment and society – typically they will screen out the ‘sin stocks’, which include anything linked to weapons, tobacco, gambling, and adult entertainment. But some ethical funds will take the exclusion process a bit further and remove a larger range of activities, such as deforestation and fast fashion.
In addition to screening out controversial sectors, some ethical funds will pro-actively seek companies that are striving to make a positive different. To make their selection, funds will use ESG (Environmental, Social, and Governance) criteria to assess the ethical profile of every company they look at. Fund managers will check a number of things like how much energy an organisation uses, how diverse its workforce is, and how transparent it is when reporting publicly. Then each company will receive an ESG score and the higher this rating, the more likely the company is to be included in the fund.
But not all ethical funds are the same! Remember the distinction we made between active and passive funds earlier? Well, here the difference between these two types of funds will have an impact on what you’re invested in. When it comes to selecting companies that do good, passive ethical funds use a rigid scoring system that looks at things in black and white, automatically excluding entire industries and judging companies solely based on their ESG score. In comparison, active ethical funds can dig into company’s credentials and consider organisations that are working hard to improve their practices and policies. They will also monitor companies and their activities to ensure they either maintain high ethical standards or continue to make progress. And that’s not all! Active ethical funds can push for change as fund managers can use their shareholder voting power to influence the overall strategy of a company. At Wealthify, although we use passive funds for our Original Plans, we prefer actively managed funds for our Ethical Plans as we believe targeted engagement by active fund managers will help drive change in companies and promote sustainability.
How to invest in funds
Before you invest, you may want to choose the types of funds you’re more comfortable with – the decision will mainly depend on your investment goals, attitude to risk, and personal preferences. Then you can start thinking about investing in funds. There are two main ways to do this. You could pick your own funds using a DIY platform, but this approach requires time, a lot of research, and a bit of financial knowledge. So, if you’re too busy or don’t feel confident enough to do it on your own, that’s fine, there are many investment services that could help you get started.
With robo-investors, like Wealthify, you don’t have to do any of the hard work. In fact, our team of experts will do the technical bit for you, from picking the right funds to adjusting your Plan when needed to keep it on track with your investment style. All you need to do is let us know how much you want to invest, choose the risk level that suits you and whether you want to invest in our Original plans that use passive funds, or our Ethical plans that use actively managed funds – we’ll take care of everything else. Who knew investing could be that easy?
The tax treatment depends on your individual circumstances and may be subject to change in the future.
Please remember the value of your investments can go down as well as up, and you could get back less than invested.