What Is An Investment Fund?

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by Forbes

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What Is An Investment Fund?

For individuals who want to grow their wealth and have a time-frame of at least five years, investing in the stock market could offer greater returns than cash savings.

It can also help savers to beat the corrosive impact of inflation on their cash. While there are no guarantees, historical data shows that stock markets tend to grow at or above inflation rates in the long term (as measured in decades).

Investment funds are a popular option for both new and experienced investors. These funds pool cash from many individuals, and use it to buy a range of assets such as stocks and bonds. Gains and losses are then split between investors.

Investment funds are generally considered lower risk than investing in a single company, since they allow investors to diversify their holdings and effectively spread the risk.

Here's a breakdown of what new investors need to know about funds.

Investing in the stock market is not suitable for everyone. With any type of investment capital is at risk, and the value of investments could fall as well as rise.

Before going down the investment route, it's sensible to build up a cash fund worth at least three (preferably six) months' living expenses.

Investment funds allow individual investors to pool their resources.

Alone, one person might be able to invest, say, £1,000 - but 5,000 such investors would, collectively, have £5 million to invest, giving them great collective buying power.

When multiple investors band together, they can also split fund management costs, and invest in shares they couldn't otherwise afford.

These pooled resources are used to purchase an array of financial assets. Funds usually - but not always - comprise a single asset type, such as bonds or equities.

Investment funds can be managed in a couple of different ways: either 'actively' or 'passively'.

Actively managed funds are overseen by a dedicated fund manager, who selects investments with the goal of outperforming a certain benchmark or index.

By contrast, passively managed funds aim to mimic the growth of a certain market by using a computer to track a specific index. For this reason, they're often called 'tracker funds'.

A passively managed fund tracking the FTSE 100, for example, would buy shares in each of the 100 companies that make up the index.

Because they require less input, passively managed funds typically come with lower management fees.

As of January 2023, UK investors held around £1.4 trillion in investment funds, according to data from the Investment Association.

Worldwide, more than £91.81 trillion ($111.2 trillion) was held in investment funds in 2020, according to PwC.

While all funds operate under the same principle of pooling resources, there are several kinds to choose from. In the UK, these include:

Open-ended funds are a type of actively managed investment. They're referred to as 'open' because there's no cap on how much money they can accept in total from investors.

When investors buy into an open-ended fund, they receive a 'unit', the value of which fluctuates in accordance with the value of the fund's underlying assets. Units can be bought and sold at any time, at a value that's calculated once per trading day.

Open-ended funds usually fall into one of two categories: open-ended investment companies (OEICs), and unit trusts. Although they're very similar, they're priced differently.

Unit trusts are given two daily prices - a price for buying ('offer' price), and a lower price for selling ('bid' price) - while OEICs usually have a single daily price.

For this reason, unit trusts are considered a longer-term investment as, in order to profit, investors must wait for the fund's sell price to exceed the buy price they initially paid.

OEICs are governed by company law, while unit trusts fall under trust law.

Unlike their open-ended counterparts, closed-ended funds have a limited number of shares instead of limitless units.

These shares can be traded through a stock exchange in the same way as company shares.

The price of each share in a closed-ended fund is decided by supply and demand, so doesn't necessarily reflect the value of the fund's underlying assets.

Investment trusts are a common type of closed-ended fund.

Exchange traded funds (ETFs) are a type of passively managed fund that invests in a collection of assets in a particular area - such a specific geographical region or industry.

ETFs are open-ended, so investors can buy and sell units whenever they want, and there's no limit on how much can be invested in the fund in total.

Index or tracker funds are a type of passively managed fund that aims to replicate the movement of a specific index, such as the S&P 500 or FTSE 100.

They do this by investing in most, or all, of the companies that feature in a certain index.

Tracker funds are typically open ended, and investors can buy and sell units at any time.

When you invest in a fund, your cash is pooled with that of other investors, and used to buy shares, bonds, or other assets.

Each fund has a manager, who is responsible for guiding the fund towards its stated goals. In practice, this means buying and selling investments (either using human judgement or a computer program), and monitoring performance.

When investors buy a unit in a fund, they are typically offered two investment options:

When selecting funds, considering your personal goals is a good place to start.

Younger investors, for instance, may have a higher tolerance for risk than those who are approaching retirement, and could be comfortable selecting funds that skew towards shares, which offer higher growth potential, but higher risk.

Conversely, funds that heavily feature bonds tend to offer greater stability, but lower growth potential.

Investors might also select funds that align with their values. For instance, you might select funds that offer exposure to an emerging market, or a sector you believe in, such as life sciences or renewable energy.

Many funds explicitly focus on investments that meet certain environmental, social, and governance (ESG) criteria.

Cost is another important factor, as fees and charges eat into the value of returns. That said, the lowest cost option is not necessarily the best. A fund that charges relatively high fees but outperforms its peers may offer better value overall.

Checking whether the fund has met its benchmarks in the past could also give you a rough idea of how it may perform in the future - though there are no guarantees.

Most funds release a factsheet that includes performance history, a summary of its goals, and a breakdown of how the cash is invested.

Data websites such as Morningstar and Trustnet also offer information on funds, along with investing news and analysis.

If you're unsure where to start, several major investment platforms, including Hargreaves Lansdown and AJ Bell, compile a shortlist of recommended funds.

Investing in funds comes with key advantages:

As with any investment, there are also some potential drawbacks:

Open-ended funds may also become vulnerable if too many investors pull their money out at once.

One prominent example is the Neil Woodford Equity Income Fund, which collapsed in the summer of 2019.

Known for his 'star' stock picking abilities, Woodford launched the fund in 2014, attracting significant interest. By 2017, the fund had assets under management valued in excess of £10 billion.

Woodford had invested heavily in illiquid assets - holdings that can't be quickly sold - particularly shares in private companies. These shares offered high growth potential, but were riskier than investments in more established, listed companies.

When some of the companies in which Woodford had invested issued profit warnings, confidence in the fund waned and investors began to withdraw their cash.

To meet these withdrawal requests, Woodford was forced to sell the liquid assets he had, tipping the fund's balance even further towards illiquid holdings.

Eventually, withdrawals were frozen and remaining investors could not access their cash. The fund was broken up in 2019, losing 400,000 investors £1 billion.

Many are still waiting to get some of their money back.

Exactly how much you'll pay to invest depends on the funds you pick and your investment platform.

Below are the main costs to consider:

Each fund charges its own annual fee - usually referred to as its ongoing charges figure (OCF) or total expense ratio (TER).

This covers the cost of managing the fund, and usually ranges from 0.75% to 1.00% the value of your holdings for actively managed funds, or 0.1% to 0.85% for passively managed tracker funds.

Investment platforms may charge an annual fee for holding funds in an investment account. This could be a flat fee, or a percentage of your portfolio value - usually in the region of 0.25% to 0.45%.

Some providers don't charge a platform fee, while others only charge customers for holding funds, but not shares. Where a platform fee is charged for holding shares, this is sometimes capped at a maximum amount, generally around £40 per year.

These are flat fees charged by an investment platform when customers buy or sell assets.

Some major platforms - such as Fidelity, Bestinvest and Hargreaves Lansdown - do not charge dealing fees for funds.

Some investors may also have to pay tax on the profits they make by investing in funds.

If you invest through a tax-free wrapper such as an ISA or SIPP, there's no need to pay tax on any returns.

Without this tax-free wrapper, however, investors may be liable for the following taxes:

Individuals who receive dividends on their investments may need to pay income tax.

Each UK resident can currently earn up to £2,000 in dividends each year tax-free. Any dividends income above this threshold is counted towards their annual income for tax banding purposes.

From 6 April 2023 this allowance will be cut to £1,000. It will be cut once again, to £500, from 6 April 2024.

Dividends above your allowance are taxed at 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers, and 39.35% for additional rate taxpayers.

For example, if someone earned a salary of £25,000, and £3,000 in dividends, during the 2023-24 tax year, they would have a total income of £28,000 and so fall into the basic rate tax band.

This means they would pay no tax on the first £1,000 of their dividends, and 8.75% on the remaining £2,000 (£175).

Investors who make a profit of more than £12,300 each tax year through selling their investments must pay capital gains tax.

This allowance will be cut to £6,000 on 6 April 2023, and further reduced to £3,000 from 6 April 2024.

The rate investors pay depends on their tax band and the type of asset sold.

Basic rate taxpayers pay capital gains tax of 10% on any earnings above their annual allowance. Higher and additional rate taxpayers pay 20%.

Investors can buy and sell investment funds directly from a fund manager, through a trading platform, through a robo-advisor, or through a financial advisor.

If you choose a trading platform, you may be charged dealing fees each time you buy and sell.

When you place an order for a unit in a fund, the price you'll pay is determined by the next daily valuation. This means you won't know the exact price beforehand.

Investors should typically look to hold their units or shares in an investment fund for at least five to 10 years, to weather any volatility from stock market downturns.

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