Funds

Funds are pooled investments, where investors place money to be managed by qualified fund managers. All these smaller amounts of money are added together and invested in a range of assets, usually grouped by a certain theme. This article will explain the different types of funds available to UK investors, with a guide for beginners getting started. We also list the top investment funds.

What Are Funds?

Investment funds come in various forms, but all are fundamentally similar products: a range of assets chosen and managed by a professional using a pool of capital from investors.

The investments in a fund usually have a common factor – the fund might cover emerging markets generally or a specific country or region like East Asia; alternatively it could follow an index like the FTSE 100 or a sector such as UK infrastructure. Most funds have investments in at least 30 different assets, but the list can go up to the hundreds. The investors effectively own a part of every asset in the fund.

Since a fund’s value is defined by the overall performance of a basket of assets, they are generally less risky than investing in individual stocks. Any extremes in the basket are balanced by the performance of the other assets.

This, together with the advantage of having a professional firm in charge of investments, make funds a popular choice for investors with long-term goals.

Active Vs Managed

Funds can be actively or passively managed. The difference comes down to whether a manager making active trading decisions to try to outperform the rest of the market. If not, the fund’s performance will usually track an index and it will be counted as passive.

Actively managed investment funds tend to incur higher fees to pay for the services of the fund manager, regardless of the fund’s performance.

Many investors prefer passively managed funds such as index trackers, which simply follow the performance of an index, such as the FTSE 100. Since these indices offer a broad view of a financial market or country’s economy, they can grow over a long enough timeframe and will usually outperform human managers.

There are three main types of traditional funds available to UK investors:

• Unit trusts – A type of investment fund in which investors’ funds are allocated by a fund manager and the pooled assets are divided into units.
• Open-Ended Investment Companies (OEICs) – As this type of fund is registered as a company, new shares are created when investors buy in.
• Investment trusts – These public limited companies (PLCs) seek to profit by investing in other companies, and are traded on the London Stock Exchange (LSE).

One of the most popular alternative types of funds among retail traders in recent years is exchange-traded funds (ETFs). We unpack these in more detail below.

Additionally, investors should note the distinction between income funds, which pay out income generated from dividends and other sources to investors as cash, and accumulation funds, where income is reinvested.

Unit Trusts

Unit trusts are a type of fund where investors’ capital is pooled and invested by a fund manager in bonds or stocks to make a specific return. The value of the pooled assets is divided among investors in units.

Unlike OEICs, which only quote one price, both a bid and ask price are quoted for units. This spread helps protect investors from dilution by new investors buying units or old ones selling them.

When there is a higher demand for units (more buyers than sellers) the price will be quoted on a ‘bid’ basis – the bid will be held at the actual value of the units – and if there are more sellers than buyers the price will be quoted on an ‘offer’ basis – the offer will be at the actual value of the underlying units.

Since unit trusts are open-ended, new units are formed and underlying assets are bought to satisfy the new units created with new investment. If investors start to sell in numbers, that is ‘redeeming’ their units, the fund will have to sell some of its investments and cancel units.

Investors in unit trusts are often charged extra to make their first investment, and this charge can be as high as 5–6%, particularly if a commission is due to the financial advisor who recommended the fund. However, if the investor invests through a fund supermarket or discount broker, this charge could be as low as zero.

Management charges will continue to be levied throughout the investment’s lifespan, and these are paid by the cancellation of units. These charges can be from 0.5% for index tracker funds to 2.5%.

These management charges include transaction fees, audit fees, and annual management fees, and are payable each year whether or not the fund makes a profit.

OEICs

Like unit trusts, OEICs pool investors’ money and allocate it to a range of assets across a specific sector or market. They are also open-ended funds that create new shares to meet the demand of new investors and cancel shares when investors leave.

Prices for both unit trusts and OEICs are normally calculated once per day, and this is the price at which all requested trades are executed. There will be a cut-off time for orders to be given to the fund manager for execution (so that he can amalgamate and net off buys and sells), which means that some orders won’t be executed until the following dealing day.

OEICs are priced differently to unit trusts, with just a single price quoted and initial charges levied separately. The other most significant difference between the two is that OEICs are companies listed on the London Stock Exchange, and thus governed by company law as opposed to trust law. This means that OEIC shareholders own the underlying assets the fund invests in, whereas technically, unit trust investors do not.

Investment Trusts

Investment trusts are companies whose shares are quoted on a stock exchange. Shares are issued to raise money, and then that money is used to invest. Whereas some companies might manufacture white goods, others sell banking services, etc. investment trusts make money by investing in the shares of other companies.

Because they operate like any other company, investment trusts can borrow money or issue new shares to raise money to invest.

They have a set number of shares in existence, and, unlike OEICs and unit trusts, can’t create new shares to satisfy investor demand. The price of investment trust shares will fluctuate with supply and demand. When more investors want to buy the shares, the share price will rise.

However, unlike the shares of other publicly quoted companies, the real value of investment trust shares can be easily calculated at any moment by adding up the value of all its holdings and then dividing by the number of shares of the investment trust. The sum of this calculation gives the Net Asset Value (NAV) per share.

Buying the shares of an investment trust does not incur the charges that buying units in an OEIC or units trust does, but there will be a spread between the buying and selling prices, as well as a broker’s commission and stamp duty on the purchase value. Annual management fees are payable by the investment trust, though this is usually offset by income received on its investments.

ETFs

Exchange-traded funds are a type of investment instrument that has increased in popularity in recent years – climbing from $1.35 trillion worldwide in 2011 to nearly $10 trillion in 2022.

While some ETFs are actively managed by investment professionals, they are usually passive instruments that simply track the performance of a group of assets.

ETFs usually track the performance of a specific market, sector, country or another grouping, and to do this they might invest in hundreds or even thousands of securities. Some of the most popular ETFs track the performance of major indices, such as the S&P 500.

To do so, they would either invest a weighted amount in all of the securities included in the index, or invest in a selection of assets that provide a balanced overall picture of the index’s performance.

Passive ETFs usually have low fees and pay dividends. Investment trusts can outshine ETFs on both counts, but they also tend to be more volatile compared to low-risk ETFs on offer.

Shares in ETFs are traded on stock exchanges, meaning that you can buy and sell them multiple times per day, unlike unit trusts and OEICs. This also allows traders to use different investment vehicles to trade ETFs, whose price movements can be speculated upon through contracts for difference (CFDs), for example.

ETFs that track a particular index work in almost the same way as index tracker funds. However, since ETFs are traded on stock exchanges, you will normally be subject to share dealing fees when you buy and sell them, unlike index trackers.

Mutual Funds Vs ETFs

It is widely said that an ETF behaves like a mutual fund, but can be traded like a stock. If an ETF behaves like a mutual fund, are there really any differences or similarities between ETFs and mutual funds?

Similarities

There are some areas of similarity between ETFs and mutual funds. These can be summarised as follows:

Transaction Costs

In terms of transaction costs, ETFs and mutual funds provide some of the cheapest ways of transacting in the financial markets. Transaction costs for these two assets are lower than if the trader were to be investing in the traditional stock, commodities or forex markets.

Assets Traded

ETFs and mutual funds both provide avenues for investors who want to invest in multiple securities or assets from one investment vehicle. This can be achieved with exchange-traded funds as well as mutual funds.

Retirement Investing

Leveraged ETFs can be used for retirement investing as this ETF type employs less volatile assets as the majority constituent of its asset basket. Mutual funds are also suitable for retirement investing as they are by their very nature, required to invest in less volatile assets that produce steadier returns.

Differences

Even though ETFs are similar to mutual funds in a few ways, there are also some differences in the mechanics of both investment vehicles. Some of these differences are subtle, while other differences are quite huge.

Mechanism Of Trading

This is where a big gulf exists between the two. ETFs are traded like stocks, meaning that they can be traded by either taking a long position or short-selling them. In addition, ETFs are traded in such a way that they mirror the performance of the basket of securities that they are trading and not in an attempt to outperform them.

Mutual funds, especially actively managed mutual funds, are managed in such a way as to outperform the indexes that they are tracking.

Another difference between ETFs and mutual funds in terms of the mechanics of trading has to do with pricing. ETFs can be bought and sold at the prevailing market prices, or a different price than the market price using pending orders, just the way a stock is bought and sold.

Mutual funds can only be purchased at the closing price of the day. So this means that ETF traders have more flexibility in terms of pricing, as they can take advantage of the intraday price movements of the ETF they are purchasing or short selling to get them at prices that they find cheaper to their portfolio.

A mutual fund trader does not have such privileges. Even if the price of the mutual fund asset assumes a cheaper dimension during the day, that trader must wait for the day’s trading to close before he can purchase at the closing price.

Taxation

Mutual fund investors are typically expected to pay capital gains tax on their investments. This is usually a result of the system of rebalancing portfolios with mutual funds.

ETF portfolios are rebalanced differently. When adjusting the weight of the components of the ETF, no sale of the security actually occurs, so there is nothing to tax.

This is not to say that when the ETF is sold, the trader does not pay capital gains tax. What we are saying here is that there are fewer taxable occurrences with an ETF portfolio than there are with a mutual fund portfolio, so ETF investors get to pay less tax than mutual fund investors.

Trade Process

Since ETFs are often contract-for-difference instruments, traders are allowed to buy any number of units that they want, in conformity with the leverage and margin requirements of the ETF account. Mutual fund investors have to buy preset minimums as stipulated by their fund providers.

Transparency Of Reporting

Mutual funds are only obligated to report their facts and figures as pertains to their business every quarter, or 4 times a year. In contrast, ETF brokers are required to make daily reports of the transactions that have occurred on their accounts. This provides better transparency of reporting for ETFs than mutual funds, and enables traders to take decisions faster on what to do with their portfolios and what adjustments need to be made.

Investment Profile

Mutual funds are by the nature of their design, intended to be less speculative instruments. ETF CFDs are traded daily on the exchanges and have a more risky profile because of the potential for speculation.

ETFs and mutual funds provide excellent methods of investing in the financial markets, but a trader has to weigh his personal circumstances against the inherent nature of these two investment vehicles to decide which will serve him better.

Why Invest In A Fund?

Investment funds are popular among UK investors as they tend to be lower risk and lower effort than investing in single stocks, and they provide portfolio diversification.

Funds are usually long-term investments, and investors are sometimes advised to allow five years or more to make a decent return. This doesn’t mean you will need to wait that long to cash in and profit, but you should bear in mind that funds’ timeframes tend toward the longer term.

Since funds are usually based on a specific theme, they can be a good way to gain exposure to a certain sector or region without having to conduct deep research on the assets available. If you want to invest in natural resources, for example, you can simply research the funds available and pick one that you feel is well managed and performing well, rather than researching individual mining firms.

This also allows investors to access foreign stock markets without having to sign up with specific stockbrokers or go through complicated bureaucratic processes. A fund specialising in South East Asia will include numerous companies’ stocks that may not be easily accessible to an individual investor from the UK.

How To Choose A Fund

UK investors have thousands of funds to choose from. Consider these areas when taking your pick:

Availability

Not all investments funds are offered by every broker or trading platform. This narrows your choices down, particularly if you are investing in a stocks & shares ISA, where the assets available can be limited. If you want to invest in a specific fund, you will need to sign up for a provider that offers it.

Fortunately, the best brokers with funds, such as Degiro, have a straightforward search and filter function so users can find popular investment funds.

Degiro – Investment Fund Examples

Purpose Of Investing

Different funds will suit different purposes in an investment portfolio. If you want to put together investments that will appreciate over time to save for retirement or a specific purpose, you can look at accumulation funds with the potential for high growth. Investors seeking passive income can look for high-yield funds.

Funds in commodities such as precious metals can work well for hedging purposes, or investors could pick up an ETF which takes a short position on an index, such as the ProShares Ultra Short SQQQ.

Historic Performance

Even if past performance is no guarantee of future results, it is still a good idea to check how a fund has been performing before you invest. It may be better to avoid funds that have been underperforming for a long time as this could indicate issues with the management.

Management

The management of an active fund is the key feature that sets it apart from similar investing instruments.

A well-managed fund can outperform the market, so look for options that are helmed by highly rated professionals with strong track records.

Fees

Whichever fund you invest in will be subject to fees, but the amount you pay can vary, usually depending on how actively the fund is managed.

Some funds include a higher fee for the first investment, followed by a smaller percentage cut from any future investments you make in the fund. Many also charge a yearly management fee.

Note that unit trusts are subject to a bid and ask spread, which is effectively an additional charge when the investor sells.

Besides fees associated with the fund itself, investors will also usually need to pay charges to the broker or investment platform they use for trading.

How To Start Investing In Funds

UK investors can get started with funds by following a few simple steps:

1. Choose A Platform – Units or shares of funds are purchased through investment platforms provided by banks or established firms like Vanguard and Fidelity, while ETFs can be bought through brokers such as Pepperstone or XTB. Choose one that fits your investment goals.
2. Sign Up – You will need to complete an application form and provide identification verification and proof of address to sign up for most investment platforms and brokers in the UK.
3. Deposit Funds – Deposit enough cash in your account to purchase units or shares in all of your preferred funds. Most fund brokers will have a minimum deposit requirement.
4. Research Investment Funds – Choose the funds that meet your investment goals. A good investment portfolio could include several funds to cover various sectors.
5. Place An Order – You can split a lump sum between several investment funds or set up a recurring purchase on some platforms.

Taxes

Most funds are subject to taxes in the UK, so investors may have to pay capital gains and dividend taxes if their earnings exceed the yearly limits.

However, capital gains taxes can be avoided by investing in funds through a stocks & shares ISA (up to the £20k annual limit)

Trading US-Listed Funds

Although UK investors can buy stocks listed on US or other foreign exchanges, UK regulations prohibit the sale of US ETFs in the UK.

Fortunately, many of the most popular US ETFs have equivalents available on UK exchanges. For example, you can use the iShares Nasdaq 100 UCITS ETF to track the Nasdaq 100 in the same way as you would with the US ETF.

Alternatively, UK investors can get around the regulations by trading the US ETFs through derivative products like CFDs. These are not prohibited as they do not involve buying the underlying assets.

Bottom Line On Investment Funds

Most investors neither have the time, the experience, nor the inclination, to actively manage their investments on a day-to-day basis. Although researching the stock market and selecting stocks to buy and sell can be a rewarding process, many prefer to leave it to professionals and invest in the stock market or other assets by investing in funds. Ultimately, they can be less risky and require less effort than investing in individual stocks and assets.

FAQ

Article Sources

UK investment fund data – The Investment Association

Regulated fund data – Statista

Blackrock investment fund list

Further Reading