How do I invest my money?
The risk of investing directly in individual shares (or bonds or property) is that if the price of your asset drops significantly in value, or the issuing company goes bust, you will be overexposed and could suffer extreme losses in your portfolio from which you will have difficulty recovering.
The key to reducing this risk is having a spread of investments both within particular asset classes and between asset classes themselves.
So rather than buying shares in one company, you might buy shares in 10 different companies to diversify your portfolio and help spread the risk around. If you then add some bonds and property to the mix, you have the makings of a diverse investment portfolio
However, for some asset classes, such as corporate bonds or property, it’s pretty impractical to build a diverse portfolio of investments to spread risk if you're investing directly.
You might have enough money to buy a buy-to-let property as an investment, but do you have enough capital to build a portfolio of 10 or 20 properties? What's more, you might not know which the best companies to invest in are or, more importantly, which ones are going to give you the best return.
What is an investment fund?
Investment funds are collective investment schemes which pool your money with that of other investors to give you a stake in a ready-made portfolio. Two of the most popular types are unit trusts and open-ended investment companies (OEICs).
An investment fund can offer a practical and affordable way to invest in lots of different assets without the pressure of making your own calls on individual stocks and shares.
Tracker funds buy all the shares in a particular stock market and just follow the direction of the market.
These are known as passive investment funds. If you opt for an actively managed fund, investment decisions - like what shares to buy and when to sell - are made on your behalf by a professional fund manager who aims to either beat the market or adopt a more conservative strategy in order to preserve capital when the market falls.
What are unit trusts and OEICs?
Unit trusts and OEICs are by far the most popular investment funds. With a unit trust, a fund manager buys bonds or shares in companies on the stock market on behalf of the fund.
The fund is split into units, and this is what you’ll buy. The fund manager creates units for new investors and cancels units for those selling out of the fund. The creation of units can be unlimited, hence why the fund is ‘open-ended.’
The price of each unit depends on the net asset value (NAV) of the fund’s underlying investments and is priced once per day. This means that the value of the units you buy directly reflects the underlying value of the investment.
OEICs operate in a similar way to unit trusts except that the fund is actually run as a company. It therefore creates and cancels shares rather than units when investors come in and go out of the fund, but they still directly reflect the value of the assets that your fund manager has invested in.
How do unit trusts and OEICs pay returns?
Returns from funds are typically paid through distributions. These can be monthly, quarterly or every six months, depending on the type of fund that you invest in.
These distributions derive from the dividend payments received by the fund from the underlying shares within which they invest, or interest payments from bonds or even rental income in the case of property.
Most unit trusts and OEICs will give you two options to choose from for payment – income or accumulation. Income units pay the distributions as income, while accumulation units wrap up those distributions and reinvest them in the fund, to increase the capital value of your investment.
While income payments, or the compounding of income within a fund through accumulation units, is often a major attraction for fund investors, most will also be looking for some capital growth in the long term. So fund managers will also invest with a view to growing the value of their assets over time, sometimes more aggressively in the case of growth funds.
Find out more: Dividends can play a powerful role in generating an income from equities. Use our dividend tax calculator to find out how much you'll pay in 2017-18.
Where can unit trusts and OEICs invest?
There are over 2,000 different unit trusts and OEICs available to investors in the UK, investing in over 30 sectors.
These sectors have been categorised by the Investment Association (IA) and are split between the asset class (such as funds investing in equities, fixed interest, and property), geography (such as UK Equity, North America, Japan and Emerging Markets), sector type (such as Technology and Telecoms) and investment style (such as Growth or Income).
Unit trusts and OEICs have evolved a lot over the years and no longer invest simply in one asset, sector or region.
For example, the IA lists three sectors of managed funds - Mixed investment 0-35% shares, Mixed investment 20-60% shares and Mixed investment 40-85% shares - which invest in multiple assets to provide investors with a diversified portfolio housed within one fund.
There are funds that invest in other funds, called multi-manager or fund of funds. Rather than investing directly into individual assets, these funds invest in other collective investments, with the expectation that specialist managers in the various asset classes will produce top performance.
Fund charges - how it used to work
Traditionally, investors encountered two costs when investing in unit trusts and OEICs. The first was an initial fee, usually around 5%, for buying units or shares.
With unit trusts, the initial fee was usually the difference (the spread) between the offer price (the higher, buying price of the units) and the bid price (the lower, selling price) on the day of purchase. OEICs have always had just one price, and therefore the initial fee was simply a percentage of your overall investment.
In addition to this, investors paid an annual management charge (AMC). Actively-managed funds typically charged around 1.5% as an annual charge but when you take into consideration things like admin, legal and custodian fees, the total annual cost of a fund can often be much higher than the AMC.
This was often published as the total expense ratio (or TER) and was a far more realistic reflection of annual costs. Tracker funds, which are essentially run by computer, were usually far cheaper.
Fund charges - how it works now
Since 2013 for fund investments made through a financial adviser, and from 2014 in relation to new investments made through fund supermarkets, things have changed.
The Financial Conduct Authority (FCA) introduced new rules banning commission from fund charges being paid to financial advisers and brokers (such as fund supermarkets). As these commissions often totalled the full initial charge and up to around half of the ongoing charge, fund charges have reduced significantly.
Most fund groups have now all but given up on initial charges and ongoing charges have typically reduced by half, with 0.75% the new norm for AMCs on actively managed funds, rising to around 0.85% when the additional expenses are added to make up the full ongoing charge figure (OCF) which replaces the old TER.
Tracker funds, which never paid much commission anyway, have nevertheless remained much cheaper in most cases, with some index funds now charging less than 0.1% in ongoing charges.
The impact of fund charges
It may only seem like a small amount, but costs have been found to be the biggest drag on performance in investment funds. The argument for the higher costs is that you’re paying a premium for the expertise and better performance that a professional fund manager can offer.
But the charges are mandatory, even if your manager has returned less than the market or, worse still, lost you money.