This article is part of Morningstar.co.uk's Equity Investing Week.
At a basic level, investing in a fund means having a fund manager make investment decisions on behalf of the investor. Rather than following the markets and picking shares or bonds the investor decides on the size of an investment s/he wants to make and hands the money to the fund manager.
The investor receives regular reports on the fund's performance but has no influence on the investment choices short of removing his/her money from the fund and placing it elsewhere.
Buying into a fund does incur charges so an investor must weigh the advantages of joining against those of going it alone.
Spreading Risk
Many of the benefits of fund investment hinge on the importance of diversifying investments to reduce risk. Diversification can be achieved in a number of ways. Investors can spread risk across asset classes (such as bonds, cash, property and shares), countries and stockmarket sectors (such as financials, industrials or retailers).
As a general rule, holding one investment is riskier than holding two, three is safer than two, four better than three and so on. This is because all investments do not react in the same way to the same economic conditions.
For example, when shares may be suffering as a result of poor economic conditions bonds may be doing well. When Asian markets are falling, American markets may be rising, and when the service sector is providing strong returns manufacturing may be weakening. This is not to say that these comparisons reflect the nature of the market but to point out that all investments are not the same.
The risk to the investor is reduced because a diversified portfolio means that if some assets do poorly the performance of others may balance them out.
Outside Assistance
Once the need for this spreading of risk is established the investor has two choices. S/he can create his own portfolio of shares and bonds and other assets or invest in a fund. This article refers to buying shares in funds but investors should note that technically an investor buys units when investing in a unit trust, and shares when investing in an Open Ended Investment Company (OEIC), investment trust or ETF.
To compile a well-diversified portfolio requires time to research companies, market behaviour, economic conditions and the outlook. By investing in a fund an investor is effectively hiring the fund manager to do all of these things.
Each fund manager will have a different speciality reflecting the nature of the fund. For example, purchasing shares in a UK large companies fund, a corporate bond fund and an emerging markets fund should amount to purchasing expertise in each of these fields.
Extra Charges
Fund investing can be cost-effective. It is expensive to buy individual shares in a wide variety of companies especially once the brokerage fees and minimum purchase amounts are taken into account. Therefore an investor with, say, £7,000 to spend would gain much greater access to the stockmarkets by using a fund or spreading his/her money between several funds. S/he is buying a small portion of each investment in the fund with each fund share purchase.
Fund investment rather than the purchase of individual shares should be a more economical approach for most investors in terms of the range of investments. Yet funds do come with their own set of fees. Investors usually pay an initial charge when investing in the fund, which averages about 5%. Most of the initial charge goes to the adviser who sells the investment as compensation for providing financial advice but the recent Retail Distribution Review has largely put a stop to commission.
An annual management charge of about 1-2% is also levied. This charge covers the general costs of running the fund such as the management fee, the administrative costs and the brokerage costs. Investors should note that investment trusts and other closed-end funds tend to have slightly lower fees, while one of the key benefits of exchange-traded funds is that they come at a considerably lower cost compared to their managed peers.
Investment Methods
Investors typically have a choice between investing a lump sum or setting up a regular savings scheme. A lump sum tends to be a minimum of £500 or £1,000 while the minimum regular savings is usually about £50 or £100 per month. Each method has its advantages.
Whether an investor invests all at once or a little at a time depends on how much time s/he has to invest and the mix of maximising return and minimising risk that is applicable to his/her individual case.
Discipline is one advantage of regular savings schemes. Investors often chase past returns, buying funds after a hot performance streak and selling funds when returns slow or decline. This is usually a bad idea as it is a form of market timing, trying to anticipate what the market is going to do. Having a regular savings scheme means an investor is putting money into the fund on an ongoing basis regardless of the short term ups and downs in the fund performance.
Pound-cost averaging is another feature of regular savings schemes that ensures an investor does not buy shares at extreme prices.
Pound-cost averaging, a mathematical feature of regular savings, can reduce investment risk. It evens out any extreme pricing levels within the fund by spreading the money invested over a period of time.
If, for example, an investor has £6,000 to invest and begins by placing £500 in the fund every month, part of his/her money will be in cash and part invested in fund shares. If the market drops, the cash portion has not lost its value and s/he can now buy shares in the fund for a reduced price--obtaining more shares for less cash. In the same way that pound-cost averaging will net him/her more shares in a declining market it can also curtail losses if the fund price falls.
One idea is to combine the two strategies: Invest as much as possible today and vow to invest a little more each month or quarter.
