In our last post we discussed the 3 main types of investment fund. In this next post in our series on funds, we'll go on to look at a fund's aims and objectives.
Are you investing for growth or income, or both?
You should consider whether you are primarily investing for growth, income or for both. If you want some income, but no risk to your capital, you can choose a money market or cash fund. If you are willing to take some risk with your capital, you can choose a fund that invests in bonds, which provide a rate of interest higher than is available with cash. Alternatively, if your objective like mine is long-term growth, you can choose a fund which invests in shares. There are also equity funds that invest in shares of companies that aim to generate income rather than capital growth.
Some funds offer a mixture of both shares and bonds. Personally, I invest in funds that are 100% shares. However, some of our more cautious clients use a combination of shares and bonds. There are also types of funds that are protected or guaranteed that limit losses if the market goes down, or to give you assurance that you will get back at least a certain amount after a specified length of time. I’ve never used protected funds before and it is unlikely that they’ll grow as fast as unprotected ones when the stock market is performing well, as you have to pay for the cost of protection.
A fund's investment style
You might also want to think about the fund's investment style. For example, some funds that aim for higher returns over the long term are called aggressive funds. This usually means the fund could reap attractive returns over the long term but will be volatile in the short term. However, a fund adopting a more cautious approach may see a lower return over the long term than its aggressive neighbour but is less volatile in the short term. Even though they’re not suited for everybody, I really like growth funds due to my adventurous risk profile and very long-term investment horizon.
Continuing with the theme of investment style, some funds invest in small companies. This normally implies they are higher risk. When having the choice between investing in a fund that invests in small, medium or large companies, I normally choose large because larger companies have proved themselves and are more established than there medium and smaller counterparts. In the case of share and bond funds you will want to think about the focus of the fund: some funds specialise in, for example, a geographical area (e.g. North America) or in a particular sector (e.g. technology).
9 different types of funds
Funds come in all shapes and sizes. Here are 9 types to take a look at:
1) Mixed funds: These are funds which diversify between different types of investment, meaning they invest in a mixture of cash, bonds, shares, property and derivatives.
2) Socially responsible funds: These invest only in companies which meet certain ethical criteria, for example avoiding tobacco companies or those that test on animals.
3) Managed funds: In general, an active fund manager's aim is to reduce risk and generate better returns than their benchmark, through in-depth research and a long-term outlook on companies' development. Managed funds do not track a particular index and instead aim to outperform one. The fund manager invests in different companies that are carefully selected according to the fund's brief. For example one fund might invest especially in European smaller companies whilst another might focus on larger companies based in North America. The fund management company's analysts assess the suitability of individual stocks for their particular fund. By leveraging their expertise, your money could be invested in 30–100 companies at any one point in time without you having to worry about making investment decisions yourself. This type of fund is my favourite because if you choose well, you can outperform the market and generate an excellent return.
4) Tracker funds and Exchange Traded Funds (ETFs): A passive fund or index tracker is designed to replicate the performance of an index. Index tracker funds attempt to track the movement of a stock market index. This means your investment reflects proportionately the companies listed in a particular index – the FTSE 100, for example. When using tracker funds, the stock market index that your fund aims to replicate will play a huge part in dictating how well your investment performs. You can get a good idea for how your index tracker is behaving by looking at charts of the stock market index your fund is aiming to mirror.
Anyone investing in an Exchange Traded Funds (ETFs) must accept these are relatively new and unproven. Because of charges, cash drag, and the other factors, there will always be a difference between the performance of the ETF and the investment it tracks. This difference is referred to as the ‘tracking error’. Tracking error also occurs on tracker funds as well as ETFs. In an ideal world, if the FTSE 100 Index returns 10% each year, then a FTSE 100 tracker fund or ETF will also return 10%. But the world isn’t perfect and tracking error shows how wide of the benchmark index the performance is.
That’s important information if you are presently a passive investor because it can reveal the hidden cost of owning tracker funds and ETFs. ETFs are traded on a stock exchange which means you’ll have 0.5% Stamp Duty to pay every time you make a trade. You’ll also have the bid-offer spread to pay and if the fund is illiquid, the spread could be 5–10%. Even though tracker funds and ETFs publish lower annual charges (TERs) when compared to actively managed funds, 95% of the funds I use for my ISA and SIPP are actively managed, however I do occasionally use them. I especially like trackers for non ISA and SIPP investment capital.
5) Offshore funds: Investing in offshore funds could have certain advantages, particularly but not exclusively to international or expatriate investors. These funds are taxed differently to other investments operating under the tax regime of the country where they are located. Contrary to popular belief, offshore funds offer no particular advantage to investors resident in the UK as profits are still liable to UK tax when they are cashed in. If you are planning to retire abroad, investing offshore may make sense. However, this would be dependent on your own situation and the tax laws of the country to which you are retiring. Remember that for funds that invest in overseas markets, changes in currency exchange rates may affect the value of an investment.
6) Property funds: You could choose to invest in a property fund, rather than buying property yourself. Property funds invest either directly or indirectly in property or property-related assets. A fund that invests directly will buy physical property such as a shopping centre in order to generate rental income. A fund that invests indirectly will purchase more liquid asset such as property derivatives, Real Estate Investment Trusts (REITs) or shares in a property company. When investing in property funds, you can invest smaller amounts when compared to traditional property investing and if you need to, it is generally easier to sell a fund investment than a property. Your money will be spread over a large number and types of properties and some funds further reduce risk by investing in several different countries. You won't have the inconvenience of handling the property deals yourself and the worry of maintaining the buildings is removed. Even though there are benefits, you also need to consider that some property funds impose restrictions on redemptions, which can mean that your money may not be available to you quickly if you need it. You also need to be vigilant of downturns in the property market.
7) Fund of funds (multi-manager): Funds of funds and multi-manager funds are designed to give you a chance to invest in a range of funds rather than a range of shares. This means the fund manager buys other investment funds instead of the traditional approach of buying shares in companies. Fund of funds provide an alternative to putting together your own portfolio, monitoring it and making changes. These benefits can come at a significant cost in terms of higher charges. The fund of funds manager may impose its own charges, similar to any other manager. However, as a fund of funds invests in other underlying funds, which will also have ongoing charges, the investor is hit with two sets of costs. This results in you paying total annual costs which could be as high as 3% a year.
8) Money market funds: Money market funds are designed to offer higher returns than a building society account but have a similar level of security. They invest in bank deposits and are generally called ‘cash funds’. Some invest in short-term money market securities.
9) Absolute return funds: Absolute return funds aim to deliver positive returns (i.e. more than zero) on a 12 month rolling basis in any market condition. But this is rarely, if ever, guaranteed. If you are seeking to limit losses when markets go down then you might want to consider one of the options under the 'Capital Protection' category. These funds operate like hedge funds and normally come with higher charges and there’s also a 20% performance fee to pay. A hefty performance fee makes this type of fund unappealing to me personally.
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
ISACO is a specialist in ISA and SIPP Investment and the pioneer of ‘Shadow Investment’, a simple way to grow your ISA and SIPP. Together with our clients, we have £57 million actively invested in ISAs and pensions*.
Our personal investment service allows you to look over our shoulder and buy into exactly the same funds as we are buying. These are investment funds that we personally own and so you can be assured that they are good quality. We are proud to say that by ‘shadowing’ us, our clients have made an annual return of 12.5% per year over the last four years** versus the FTSE 100’s 7.4%.
We currently have close to 400 carefully selected clients. Most of them have over £100,000 actively invested and the majority are DIY investors such as business owners, self-employed professionals and corporate executives. We also have clients from the financial services sector such as IFAs, wealth managers and fund managers. ISACO Ltd is authorised and regulated by the Financial Conduct Authority (FCA). Our firm reference number is 525147.
* 15th November 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients.
** (31st December 2008 - 31st December 2012).
ISACO investment performance verified by Independent Executives Ltd.