Here’s a predicament that might sound familiar: going it alone and actively trading your own stocks and bonds seems too scary or too much hassle, so you decide to put your money in a fund and have someone else take the decisions for you. Simple! But then the next big question hits you: which fund? There are still thousands of bewildering options out there. And so you’re back to square one.
This Pack aims to get past the paralysis of choice by talking you through the basics of investing in funds.
Hold on, what even are funds? An investment fund (a.k.a. a mutual fund) pools together cash from many small investors (like you) and gives it to a professional fund manager to oversee. The manager can invest the money in a range of assets such as shares, bonds, commodities, property, or a combination – depending on the type of fund.
How do I know if investing in funds is right for me? Unless you feel confident enough to pick out your own portfolio of investments, you’re often better off delegating this job to someone with more experience. Investing through a fund also makes it easier to spread your investments across a variety of places, even if you’ve only got a modest sum to start out with. It can also work out cheaper to use a fund sometimes, as building your own portfolio can lead to multiple transaction costs from buying and selling each individual position.
Sounds great. Where do I sign? Hold on! Before you go ahead and hand over your hard-earned dosh to a fund manager, you first have to determine what kind of fund you want to invest in. There is an ever-increasing choice of funds available – using strategies that vary by asset classes, geography, industry, etc.
We know it can all be a bit overwhelming. But don’t worry, we’ll take you through what’s out there and how you can go about picking the right fund for you.
As we said last time, before you can stick your nest egg in a fund and settle back to feel the warm glow of checking an item of your “to do” list, there’s one important hurdle to leap: which fund (or even funds, plural) to choose? To give you the tools to make that decision, in the next two segments, we’ll outline the various styles of fund available.
What types are there? The first broad way of distinguishing between funds is categorizing them into passive and active. The manager of a passive fund (also known as an index fund or a tracker fund) is tasked with simply replicating the performance of an underlying market. Exchange-traded funds (ETFs) fall into this category.
With an active fund, on the other hand, the fund manager picks a portfolio of investments that he or she hopes will perform better than the market as a whole. However – and this is really important – there’s no guarantee they will actually achieve this. It’s all at the mercy of the manager’s skill (and luck!) in picking winners – and you’ll have to pay a higher fee for this active management.
How else do funds differ? Mutual funds can also be differentiated based on the assets the manager is allowed to invest in. This can vary from stocks, bonds, commodities, or other alternative asset classes (property, cryptocurrency, art, etc). There are also managers who can provide a combination. Within each asset class, the funds can also differ on strategy and which segment of the market they focus on.
Can you give some examples? First up, one very popular type of fund that can be found in many portfolios, particularly in the US, is a money-market fund. These invest only in cash and cash-like securities such as US treasury bills (short-duration debt backed by the American government) and commercial paper (short-term debt to corporations). Their popularity comes from their low risk and high liquidity – which means it’s easy to cash out at short notice. Returns are generally tiny, however.
Now, let’s look at stock funds – a.k.a. equity funds. They can vary by company size: there are funds focused on small-caps (generally defined as companies with a market value of between $300 million and $2 billion), mid-caps ($2 billion to $7 billion), and large-caps (above $7 billion). Smaller companies can offer better growth potential, but they also tend to be riskier as they can lack the resources to see them through economic downturns.
Another distinction between equity funds is the strategy the manager deploys – there are many of these, but two biggies are known as value and growth.
A value fund looks to invest in shares that look cheap compared to their worth as suggested by key data like the company’s profits or the value of its assets. Why? The fund manager hopes to benefit from any price appreciation as the stock converges to its real value (cha-ching!).
A growth fund, on the other hand, aims to invest in companies with above-average growth prospects. These companies tend to reinvest their profits into the business – things like building new factories or hiring staff for research and development. Compared to value funds, growth funds tend to be riskier and are better suited for people with longer investment horizons (the length of time you’re willing to hold an investment).
Apart from these broad categories, there are a whole range of equity funds lumped into the “specialist” category. These can range from those focused on sector-specific strategies, with funky names like distressed or special situations to funds that invest in other funds (referred to as funds of funds). These narrower strategies often carry a higher risk on their own, but they can be used to diversify a portfolio. For instance, an international fund invests in equities outside your home country, thereby adding geographical diversity to your portfolio.
Now that we’ve covered stocks, we’ll take a peek at other asset classes.
While many people starting out investing will instinctively turn to the stock market, there are plenty of other options out there that merit your consideration. To minimize the risk of all your investments turning sour at the same time, it’s generally a good idea to spread them around a bit. Below we will take you through funds that specialize in other asset classes, starting with bonds.
What are bonds? Bonds are loans to governments and companies. In general, they tend to be less risky as bond investors come before equity investors in the line to get paid if a company goes bust or defaults on its obligations. Bond funds complement equity funds as they have historically been negatively correlated – which means bond prices tend to rise when stocks fall. Be warned that that trend has broken down somewhat in recent years, however.
Just like equities, bonds come in various sizes and styles. For example, funds can focus on solid “investment grade” bonds, riskier “high-yield” bonds, inflation-protected bonds, and so on.
What about commodity funds? They aim to track the performance of the underlying commodity – copper, gold, oil, whatever. This can be achieved directly by investing in the commodity itself or indirectly through futures (contracts for a future purchase) or indices made up of various commodity-based assets. Commodity funds can offer some protection against inflation. They also have a generally low correlation with equities and as such can be a good source of diversification. However, be aware that commodity prices tend to fluctuate considerably over time and as such carry quite a bit of risk.
What else is there? There are also specialist funds that focus on alternative asset classes and complex strategies. They can allocate money across infrastructure, agriculture, resources, real estate, cryptocurrencies, or even art. Unless you really understand where these funds are investing your money – and why – it might be best to leave these specialist funds to more expert investors.
Do I need to choose more than one fund? While it’s important not to put all your eggs in the same basket, for those who want to keep it simple there are funds that can provide the benefits of diversification in just a single fund – they go by the name of asset-allocation funds.
With these, you decide your risk level by selecting a certain split between stocks and bonds and the fund does the rest. An aggressive allocation might be 80% stocks and 20% bonds, while a more conservative strategy might be 50-50. Another type of asset allocation fund is a life-cycle or a target fund, which starts off with more weight to risky investments but automatically shifts to be more conservative as the target date (generally retirement) approaches.
Once I invest in a fund, is my money locked in? In most cases no, but there might be different hurdles to extracting your cash. To answer this more fully, let’s look at open-end and closed-end funds. In an open-end fund, the manager is free to issue as many shares as they wish. (Yes, funds have shares too, not just companies. How confusing!) If you buy shares in an open-end fund, additional shares will be created to fulfil that demand. Similarly, if you sell shares, they are taken out of circulation. The value of an open-end fund simply tracks the value of its underlying holdings, also referred to as the net asset value (NAV). You can always remove your money from an open-ended fund, but this will prompt the fund manager to sell some assets.
A closed-end fund is a different animal: it’s created through an IPO (initial public offering) and trades on an exchange, just like any public company. The value of a closed-end fund is set by the balance of buyers and sellers of its shares. If you want to extract your money you’ll have to find a buyer for your shares. In normal times this shouldn’t be a problem, but it times of extreme market stress there may be no buyers to sell to.
Next, we’ll look at balancing risk and returns.
Once you have a good handle on your available options, your final choice depends on your ability and willingness to take a risk. Here, we’ll lay out how to approach the decision.
When picking any investment you’re making a prediction about the future – which is inherently hard. It depends on a range of factors such as your investment horizon, the amount of money you start with, your investment experience, and your appetite for risk. While high risk is generally associated with high returns, you should know that high risk can also mean higher chances of losses – a concept generally referred to as volatility.
What’s volatility? It refers to the size of price swings in a fund. Investment professionals will talk about an investment being high or low beta – a high-beta fund will tend to climb more than the overall market in good times, but fall more in bad times. They’ll also look at standard deviation, a statistical measure of how often returns differ from the average. The rule of thumb is that higher beta or higher standard deviation equals higher risk.
OK, what else do I need to know before choosing my fund? Once you have narrowed down your choices to the ones that meet your risk appetite, time frame and preferred strategy you will still be left with a big list of funds. One way to compare them is by looking at past performance, preferably five to ten years. While the past is not necessarily a good predictor of the future, it will give you a sense of the consistency of the fund manager’s track-record.
There are also several resources available online that attempt to simplify the comparison of mutual funds. One tool used by many is the fund ratings provided by companies such as Morningstar, Lipper, and Mutual Fund Observer. Before you use these star ratings, make sure you understand what they are based on as different providers will use different factors. For example, the Morningstar Rating is a measure of a fund's risk-adjusted return, relative to similar funds – while Lipper looks at total return, consistent return, preservation, expense, and tax. Which ratings you choose ultimately depends on which features you care about most.
How do I research the funds? Your first stop when researching an individual fund should be its prospectus. This is a document all mutual funds are legally required to publish and contains a wealth of information for potential investors: including the fund’s investment objective, strategy, holdings, details of the manager, risks, performance, and fees. This is generally only published at the start of the life of a fund or when the manager is trying to raise more money. On an ongoing basis, funds are also required to publish a shorter document, called a factsheet, which is a monthly report summarising the fund’s objective, investment holdings, performance, and manager’s commentary.
Beyond these basic tools, there is a plethora of resources at your disposal if you decide to really dig deep. Depending on what you are looking for there are various websites that can assist you in making the final choice. For example, if you want to compare the impact of fees on performance, you can refer to the FINRA Fund Analyser. GuruFocus is another useful platform that helps individual value investors follow the leaders in the game. To track your portfolio’s allocation and performance, there’s SigFig and many others. The good news is that most of these resources are free!
To make sure you leap into funds with open eyes, we’ll take you through the various costs and fees you need to be aware of.
The first step is to decide which route you are going to use to transfer your money into the fund. One way is via your pension. In many countries this will massively reduce the amount you have to pay in income tax, and hence leave more in your investment pot.
There are some big negatives to be aware of though. Firstly, your pension money will generally be locked away until you reach a certain age – and even if you can withdraw early the government might hit you with punitive penalties. There’s also no guarantee what the rules will be like in the future when you come to think about retiring. And finally – unless you’re self-employed – choice in where to invest your pension is often limited by your employer.
Another clever way of investing is through tax-exempt accounts. Though, again, the rules for these will vary from country to country. The UK, for example, allows people to save a certain amount each year entirely free of taxes in an Individual Savings Account (or ISA). You can do this through most brokerage accounts.
What fees do I need to look out for? There can be a long and rather opaque list, sadly. The most obvious charge is usually the management fee, which pays for the fund manager (or managers). This tends to be higher for actively managed funds than passive funds, because you’re paying them to be, well, active.
Annual fees for active mutual funds roam around the 1% range – but can easily be as high as 2.5%. While this may seem steep, in recent years fees have actually been falling, driven by competition from the passive crowd.
Some funds may also charge a performance fee that rewards them for any positive returns and additional fees to cover the operating and administrative costs of a fund. You should also be aware of any redemption fees which penalize you for selling the shares of a fund within a given timeframe.
Anything else? Funds that are identical in the assets they hold and the person making the investment decisions can have differences that cause confusion when you’re making your final selection. The same fund may have a variety of different fee structures: one where the fees are paid upfront when you deposit money, one where the fees are paid as you withdraw your cash, and one where the fees are spread across the life of your investment. These are sometimes called front-end loaded, back-end loaded, and level-loaded funds or assigned the (even more baffling) letters A, B, and C.
The other confusing variation in how funds occasionally describe themselves is accumulation and income. Again, the underlying pool of assets can be identical. But an income fund will pay out any returns to the investor on a regular basis (which can be useful if you need to live off your investments – like if you’re retired) while an accumulation fund will keep hold of any income and add it to your stash.
And finally… If you’re investing through a brokerage account, you may also be charged another fee by the broker. Phew.
After all these fees are taken into account, academic studies have shown that the majority of actively managed funds will perform less well than the overall market against which they’re judged. (For example, a US equities fund might be judged against the S&P 500 index). This has driven a steady flow of investor cash toward passive funds in recent years.
Make sure to do your research before making any commitments and get the most bang for your buck by balancing costs with performance.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.