The Expat Guide to Investing into Funds
Funds - an easier way to build your investment portfolio
This guide covers all you need to know to start investing in funds: what funds are, fund types, how they work, how to pick the funds to invest in, and more.
Choosing shares to invest into can be quite a daunting and complicated task, especially for beginners and those who don’t really have enough time to do a deep research. And that’s exactly when funds come in handy because with the funds the bulk of the work – research and management - is done for you.
Investing in funds gives you an opportunity to spread your money across various assets; it doesn’t cost much, and you can have a peace of mind knowing that a professional fund manager looks after your investments. That’s why investment funds make such a great option for both beginners and mature investors looking for an easier life.
In this guide you will find all the essential information about funds, including various types of funds and how they work, how you deal in funds, fund charges, picking funds, etc. We hope that the guide can help you decide whether investing in funds is right for you and something you are interested in.
What is a Fund?
A fund is a vehicle that allows individual investors to put their money together and buy securities while retaining ownership and control of their own shares.
Funds employ managers or managing teams to oversee the performance and make informed decisions on behalf of the investors.
A fund manager invests the capital that has been pooled together from individual investors in a wide range of assets e.g. domestic shares, overseas shares, bonds, or in alternative assets such as vintage wines, paintings or copyright rights.
Each investor is issued units, which represent a portion of the holdings of a fund.
Funds usually invest in a specific area which can based on geography (European, Japanese, emerging markets funds, etc.), industry (green companies, utility firms, industrial businesses, transportation, etc.), types of investments (shares, corporate bonds, gilts), size of the company or any other area.
The area of investment is a good giveaway of the risk factor. If the fund’s focus area is “fledgling biotech companies in emerging markets”, all the elements involve a high degree of uncertainty. So, if it goes well you could be in for massive gains, and if it goes badly, massive losses.
Advantages of Investment Funds
The main advantage of investing in funds is that by pooling their capital together the investors can share the costs and benefit from investing larger amounts. In short, they can invest in a greater number of different companies for a lower overall cost.
Investing in a fund makes a lot of sense if you don’t have the time to research, manage and monitor a portfolio of individual shares.
Funds allow you the following benefits:
• You can diversify and spread your risk across multiple individual investments.
As a fund invests in many different shares or bonds, the risk of you losing all your money is less than if you had invested in a single company’s shares. Fund managers usually have a basket of between 30 and 60 stocks.
• You can rely on a qualified fund manager or a managing team whose job is to monitor those investments and make informed decisions on your behalf.
Fund managers are seen as experts in their field and will spend most of their time researching and meeting companies to carefully select products to invest into.
• You can usually get your money into and out of the fund easily, although with many funds it’s worth investing for at least 5 years - you have a better chance of riding out short-term volatility and benefitting from greater returns.
• You can often invest for as little as £1,000 (£500 for some funds).
• The costs of buying and selling individual investments are spread across a large number of people.
However, this convenience and expertise doesn’t come free. There are fees and charges to pay, which we will discuss later in the Fund Charges section.
Investing in a fund means you save time and costs, however you have less control of the specific company your money goes towards, and you still need to do due diligence when choosing a fund.
Actively Managed Funds and Passive Funds – Which Suits You Best?
Investment funds have two main strategies of managing your money - active management and passive management.
Actively managed funds are run by a manager or a managing team who buy and sell stocks and assets constantly monitoring their performance and paying close attention to market trends, shifts in the economy, changes to the political landscape and factors that may affect specific companies.
Using this data, the managers make necessary adjustments of their holdings.
Actively managed funds usually strive to outperform the stock markets and other competing funds and that’s where a potential weakness may lay – to beat the market, active managers must take on additional market risk to obtain the higher returns.
Passive funds, also known as index funds, are based on a portfolio of stocks and shares that tracks the performance of a particular market index, so that their performance repeats the ups and downs of the market they’re following.
Managers select stocks and other securities listed on an index with the purpose to generate the same return as the chosen index instead of outperforming it. Managers of passive funds do not make decisions based on their knowledge and analysis of the stocks, and such funds’ portfolio merely replicates the index, that’s why such funds are called index funds.
Index funds can be structured as exchange-traded funds (ETF), mutual funds or unit investment trusts.
As passive funds don’t offer active monitoring and portfolio adjustment, the fees are lower than those for active management. But there are no expectations of outperforming the markets.
Multi-manager funds are funds that invest in other funds.
Such funds often call themselves “one-stop-shop” for investors as they provide investors with a well-diversified portfolio in a single investment while outsourcing all of the day-to-day management to experts.
By investing in a multi-manager fund you buy a single product which provides access to an army of fund managers looking for the best ideas, each a specialist in a certain field.
These funds can invest in shares, bonds or other securities.
There are two kinds of multi-manager funds: fund-of-funds and manager-of-managers.
A fund-of-funds portfolio holds a range of other funds run by specialist managers.
Manager-of-manager funds appoint a selection of specialist managers who make investment decisions in their area of expertise. This way the fund can invest across asset classes but still have specialists making decisions about where to invest. The role of the manager-of-managers is to select the managers and monitor their performance.
Multi-manager funds are not cheap as you are effectively paying two levels of charges, however it might be worth it if you get a better return.
Fettered or Unfettered?
Some multi-manager funds are only allowed to invest in funds managed by the same investment company, which is described as ‘fettered’.
The costs of investing in a fettered fund are usually lower. Also, the multi-manager will have constant and more detailed access to the underlying managers - often they will be sitting just a few desks away from each other. Plus, fewer managers to concentrate on allows for greater focus.
Funds that are free to invest in any third-party fund are called ‘unfettered’.
Unfettered funds have broader opportunities, not only in terms of underlying funds but also investment styles and strategies. Thus, the manager should be able to achieve greater diversification and therefore lower volatility for the same level of return (or greater return for the same level of volatility).
It’s impossible to say whether one approach is better than the other. You might want to choose a combination of the two: fettered funds for some asset classes, where the organisation believes they have strong expertise in-house - and unfettered for others.
Income and Accumulation
When looking at different funds, you will often see the acronyms ‘Inc’ or ‘Acc’ after the name of the fund. These acronyms indicate the different classes of funds. You can choose which type of units to buy to suit your investment strategy and time horizon.
Inc - an income class units: any gains made by the fund will be paid out directly into your Dealing account, ISA or SIPP. It means that you will get a certain income from your investment at regular intervals.
Acc - an accumulation class units: this class of units rolls up dividends and other forms of income and puts them back into the fund. You will get no regular income, instead you will be paid interest on past interest. The effect is that the value of each unit is going up with time and in the end, compounding will significantly boost your investment pot.
Investing in income units is a good option for those who rely on a regular income to supplement their lifestyle. For example, it is generally used by retirees to bolster pension payments.
However, if you are not desperate for cash, then accumulation – Acc – is a way to go because of the profound effect compounding will have on your investment.
Dealing in Funds
Funds are usually priced and traded once a day. Each fund has a daily valuation point (aka dealing point), normally at 12 noon when the manager works out the value per unit of the fund’s investments. This is the price at which units are bought and sold.
When you place an order to buy or sell a fund, it’ll go through at the next valuation point. This means you won’t know the exact price beforehand.
Many funds operate a cut-off time prior to the dealing point which may vary from fund to fund.
The cut-off point is the time by which an order must be placed on a given day. For example, if a dealing point is midday every day then the cut-off point may be 9am on the same day. If an order is received after this cut-off point the trade will not be confirmed and will be processed at the next available dealing point – in this case, the next day.
When investors use funds to invest in financial markets, they are charged for the running of those funds. All such fund charges are disclosed in a standard format in the Key Investor Information Document (KIID).
The fees and charges you pay in relation to investing in funds can have a real impact on the returns that you get, so it is important you know what you will pay. Here is a list of possible charges you might be facing when investing in a fund:
One-off charges before you invest
This is an initial charge, sometimes called the ‘entry charge’, - an upfront cost paid when you invest money in a fund and is deducted from your investment. This covers expenses like administration and marketing costs.
Charges and costs taken from a fund over a year
This covers the annual operating expenses of running the fund, such as fees paid for managing the fund, custody, administration and the costs of independent oversight functions. In most cases, it is deducted from the income the fund earns; for some funds, it is deducted from the net asset value of the fund.
These costs are incurred when buying and selling the fund’s underlying investments, such as broker commissions.
These are taxes levied by governments on the sale of stocks and shares or trading taxable assets (for example, paying stamp duty when investing in property).
This is charged separately as a way of rewarding the fund manager for superior returns or for outperforming specified targets.
Some fund managers choose to take a charge when you sell your investment instead of or in addition to an entry charge in order to cover their costs.
Choosing Funds to Invest
There are over 2500 available to private investors, so no wonder it is a pretty hard task to choose a fund that’s right for you.
Many investors prefer to hand over the task of picking up an investment fund to wealth management companies. Such companies have powerful resources for a deeper research and monitoring, and also establish personal contacts with fund managers to gain more understanding in a way they invest and manage the fund.
If, however, you are determined to go on your own, there is still something you can do besides comparing fees and charges (which is also important).
Diversify, but Don’t Over Diversify
Top performing funds vary from year to year, so it makes sense to invest in funds with different types of assets and in different parts of the world. By focusing on just one asset or one particular area you might increase the risk. However, over diversification is not good either as it will make your portfolio only ever average.
What can you learn by looking at historic data?
It is important, of course, to look at the past performance of the fund you are researching to see how well it has been doing. It is much harder to work out whether a fund will perform well in future - past performance is no guarantee that great returns will be repeated again, however, solid positive records still count.
Look at the Performance figures:
You can use fund analysis tools to see how volatile a fund is (how much the price goes up and down), which is measured by standard deviation. The lower the number, the lower the volatility.
This can give you an idea how consistent a fund’s returns are and whether there is a big deviation from the fund’s long-term average: for example, if a fund with average return of 10% scores a volatility of 15%, it means that the returns can vary from -5% to +25%.
High volatility can bring higher returns, however, keep in mind that it’s high risk funds that tend to have high volatility.
Beta is a measure of how sensitive the fund is to the market. The market has a beta 1 by definition. If a fund has a beta of 1, it is as sensitive as the market itself, so if the market goes up by 10%, the fund should increase by 10%. If it has a beta of 1.1, it is more sensitive and should go up by 11%. Conversely, if the market falls by 10%, the fund with beta 1.1 will fall by 11%.
An index tracker fund should have a beta of 1.
Funds with a negative beta figure tend to rise when the market falls.
Alpha measures how much value has been added by stock selection; it’s actually a measurement of a manager’s skill to pick up investments that outperform the benchmark.
For example, if a fund has a beta of 1, but when the market goes up by 10% the funds gains 12%, the extra 2% is the alpha.
If a fund has a positive alpha score, the manager has added value through selecting high performing investments. So, the higher the alpha the better.
If a fund has a negative alpha, the manager’s stock selection has detracted from value.
4. Sharpe Ratio
The Sharpe ratio is used to measure a fund risk-adjusted returns. When a fund has a higher Sharpe ratio, it means the fund’s returns are better, relative to risk that the fund took on.
There is nothing worse than to be duped into a tracker fund that pretends to be an actively managed fund with and as such charges higher fees, but never outperforms the market. That’s where R-squared come in handy.
R-squared measures the correlation of a fund’s returns to the benchmark’s returns as a percentage from 1 to 100.
An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the benchmark. Thus, index funds that invest only in S&P 500 stocks will have an R-squared very close to 100.
Conversely, a low R-squared indicates that very few of the portfolio’s movements can be explained by movements in its benchmark index. An R-squared of 35, for example, means that only 35% of the fund’s movements can be explained by movements in the benchmark index.
R-squared is not a measure of the performance of a portfolio. A great portfolio can have a very low R-squared. However, a fund’s R-squared can give an indication whether the fund just tracks the chosen index. An index tracker fund’s R-squared is usually very high (95% or above), while actively managed funds have a lower R-squared.
6. R-squared and Beta Combined
Generally, a higher R-squared indicates a more relevant and useful Beta figure.
If a fund has an R-squared close to 1 and a Beta below 1, it is a good sign. It means that the fund mirrors the returns of the market closely enough (the R-squared figure) and isn’t oversensitive to market’s ups and downs (the Beta figure).
Assessing a Fund Manager
If you are choosing an actively managed fund, assessing a fund manager is a very important part of your research. Active investments are all about managers; some would say that a manager is more important than the fund’s past data.
Fund performance figures such as mentioned above might be of little use, if the fund manager has been replaced recently. Manager longevity helps predict future success based on the past good results.
When looking at fund managers, you might want to check rating systems that evaluate fund managers’ performance, such as Citywire, FE Alpha Manager Ratings, etc. You can get a feel as to how good the rated managers are; however, ratings are not always a 100% reliable indication of a manager’s skills.
Citywire, for example, only looks at 3 years of performance which is not enough to establish consistency.
FE Alpha Manager Ratings are more profound as they examine the performance of individual fund managers over the course of their career, focusing on consistency, stock picking skill and their ability to generate performance in rising and falling markets.
Consistency is the key!
If find a fund (or a manager) that has consistently had a high alpha (i.e., has consistently outperformed) and below average risk, - you have just discovered a great investment opportunity!
Investing in Funds and Tax Implications - Get Your Tax Advisor on Board
As a taxpayer and an investor, you should understand tax implications of fund investments.
Taking time to understand the tax consequences of investing in a specific fund will help you produce a more tax efficient result overall. So, get your accountant or tax advisor on board and clarify how investing in a certain fund may impact your personal tax situation, whether the investment fails or succeeds.
Our guide does not offer investment advice, it provides information and education for investors who are looking at possibilities to invest in funds.
Do your own due diligence.
You should carry out your own independent research and verify facts and data before making any investment decision. Seek professional advice if required
Investing carries a variety of risks and it’s important you understand them before making investment decisions.
Investment decisions in funds should only be made after reading the Key Investor Information Document, Supplemental Information Document and/or Prospectus. If you are unsure of the suitability of your investment, please seek professional advice.