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The beauty of investing in funds
Know your open-ended investment companies from your exchange-traded funds – before you invest
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Ever wanted to own shares in lots of well-known companies like Disney, Apple or Unilever but didn't want the hassle of having to buy each one individually? If so, investment funds are the simple solution. Owning a single fund can give you exposure to lots of different companies or other assets. Think of it like having broadband, your land line phone, cable TV and your mobile phone all with the same provider – multiple services but just one account.
Investment funds can either be actively or passively managed. With the former, a fund manager will pick the underlying holdings for the investment collective and regularly increase or decrease positions, or even make new ones, depending on what they believe is happening in the market and where it could go next.
Funds that do not use the services of a money manager will typically track a specific index, such as the biggest companies on the FTSE or the 10 highest-yielding stocks on European markets. You generally pay lower annual fees on passive funds like tracker funds and ETFs as their management tends to be automated via computers.
UNIT TRUSTS AND OEICS
These funds invest in one or more of the main asset classes – shares, bonds, property, cash and derivatives. Both kinds are classed as open-ended investments, meaning their size isn't limited and varies according to supply and demand. Open-ended funds have no maturity date and can grow larger or smaller, depending on the number of investors wishing to buy or sell their shares or units (which can rise and fall in number).
With unit trusts, a fund manager invests in assets on behalf of the fund. Investors buy units of the fund. The portfolio manager creates units for new investors, and also cancels units for those selling out of the fund. As the creation of units can be unlimited, a unit trust is referred to as open-ended. The price of each unit depends on the net asset value (NAV) of the portfolio's underlying investments and is priced once per day. The value of the units you buy directly reflects the underlying value of the investment.
When you put money into a unit trust, you receive units and are referred to as a unit-holder, whereas OEIC investors receive shares and are called shareholders. Another key difference is that unit trusts have an offer and a bid price, whereas OEICs have a single price and a simpler pricing structure.
You will also encounter two key classes of unit trust: an income class, which distributes dividends directly into your cash account with an investment platform, and an accumulation class, where the dividends and other forms of income are rolled up and put back into the fund, so you gradually hold more units.
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INVESTMENT TRUSTS
Investment trusts are companies in their own right, quoted on the London Stock Exchange with independent boards of directors. They have a closed-ended structure, which means there is a fixed number of shares per issue, so for every buyer there has to be a seller.
This structure can be an advantage. Unlike in the open-ended sector, the company does not expand or contract in size depending on fund inflows and outflows. The fund managers can thus adopt a long-term view and do not have to worry about selling good stocks to meet redemptions during bear market conditions. Nor do they have to deal with an influx of investment during bull market runs, possibly at an inopportune time when equity valuations are frothy.
Income is one big theme which investors can play via the investment trusts, since they can stash away up to 15 per cent of their income each year in their revenue reserves. This helps to ensure they can still pay and importantly increase dividends during tougher periods, a process known as dividend smoothing.
Many trusts trade at either a discount or premium to their net asset value (NAV). For example, a trust might own shares in three different property companies. If you bought one share in each of these companies individually in your share dealing account, the total cost might be £12 if each company trades at 400p. But the investment trust might trade at £10, meaning you could get exposure to the three property companies at a 16.7 per cent discount versus owning them directly.
Trusts can trade at a premium if they invest in ‘hot’ areas where investors are keen to get exposure, such as peer-to-peer lending or high-yielding infrastructure stocks.
TRACKER FUNDS
These are designed to mirror the movements of a specific index, such as the FTSE 100. Their goal is to replicate the exact movements of the index, not beat it as is the goal for actively-managed funds who take a specific index as their benchmark.
EXCHANGE-TRADED FUNDS (ETFs)
An ETF is an open-ended investment vehicle that tracks a specific index like the FTSE 350 or S&P 500. Unlike a tracker fund, ETFs trade on a stock exchange just like an individual company share.
Some ETFs own the relevant assets so they can accurately track the relevant price(s). For example, iShares FTSE 100 UCITS ETF would buy all the shares listed on the FTSE 100 index and so should track the index very accurately.
By contrast, iShares Core MSCI World UCITS ETF would hold a sample of the MSCI World Index because it has more than 1,600 constituents which can change frequently. Sampling replication keeps transaction costs lower but the product’s return might not correspond exactly to the index’s return, resulting in tracking difference.
To avoid tracking difference ETF providers sometimes use synthetic replication. Instead of holding the underlying assets, the product replicates the performance of an index via a swap agreement. The ETF holds a basket of securities unrelated to the index and enters into a swap agreement with a counter party that is under contract to deliver the return of the underlying assets.
By Emily Perryman, personal finance editor, in SHARES magazine
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Please note the value of investments, and any income from them can go down as well as up and you may not get back your original investment. AJ Bell Youinvest do not offer advice about the suitability of their products or any investments held within them. Should you require financial advice you should consult a suitably qualified financial adviser. Tax rules can change in the future and the tax treatment depends on your personal circumstances. Past performance is not a guide to future performance and some investments need to be held for the long term.
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