Investing Basics: Mutual Funds 101

Mutual funds are collective investments that pool investors’ money to buy and sell shares or other assets in a range of companies to maximise profits and reduce risks.

Funds divide between ‘active’ – run by investment professionals seeking to outperform the market – and ‘passive’ trackers seeking to return the performance of an index or sector; the expertise and professional investment management is why you have to pay a fee for active management. More at DIY Investor.

Types of active fund are Unit Trusts, Open Ended Investment Companies (OEICs) and Investment Trusts; they may concentrate on a particular market, asset class or sector, and differ in their investment objective – either targeting regular income or long-term capital growth.

Unit Trusts, OEICs and Investment Trusts differ in the way they are constituted, which has a bearing on how they operate and potentially the risks they take and returns they can deliver.

How Does it Work?

When you invest in a unit trust, you buy a number of units that represent your share of the fund; new units are created when you invest and are cancelled if you sell your units back.

Once a day, the fund manager calculates the total value of the underlying investments (net asset value or NAV) and establishes the price a new investor has to pay for units; the price moves up and down with the value of the fund – some are dual priced, with ‘bid’ and ‘offer’ prices, others have a single price.

Since the government’s 2012 Retail Distribution Review (RDR) delivered greater price transparency the cost of ownership of actively managed funds plummeted; ‘clean’ or unbundled funds scrapped many of the previously ‘hidden’ fees and charges.

OEICs are similar to unit trusts but the fund is run as a company and creates and cancels shares rather than units.

Unit trusts and OEICs are ‘open ended’ in that the number of units in existence can, in theory, be limitless; by contrast investment trusts are investment companies that issue a limited number of shares that trade on an exchange, their price determined by supply and demand rather than NAV.

What are the Benefits?

By pooling your investment, you can achieve a more diversified portfolio than you might on your own, spreading your risk and increasing your chances of making a profit; large funds can make investments that individuals may not be able to and with lower transaction costs

Many funds are specialists in regions, such as South America, themes such as energy or high-yielding assets like certain bonds or stocks; you should be able to find a fund with the market exposure and risk profile you want for your portfolio.

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Rather than research companies yourself, a professional fund manager will do this on your behalf; as ‘institutional investors’ they sometimes have preferential access to fundraisings – often at a discount.

A fund manager may also have greater influence over a company’s strategy than an individual share holder; most funds allow investors to drip-feed their money in – if you have only £50 to invest each month, you will still be able to gain exposure to the stock market.

If its investments perform well, the value of the fund will rise and the value of your individual units will rise; you may also receive ‘distributions’, i.e. your portion of the dividend or rental income the fund has received from its assets, monthly, quarterly or every six months.

Most funds give you two options for payment – income or accumulation; income units pay the distributions as income, while accumulation units wrap them up and reinvest in the fund, to increase the capital value of your investment.

Income payments, or the compounding of income within a fund, can be a major attraction for investors; managers also look for long term capital growth by growing the value of their assets over time.

Where do funds invest?

There are almost 3,000 different unit trusts and OEICs available to investors in the UK, investing in over 30 sectors; unit trusts and OEICs no longer invest simply in one asset, sector or region.

The sectors are categorised by the Investment Association (IA) and split between asset class (equities, fixed interest, and property), geography (UK Equity, Europe and Emerging Markets), sector (agriculture, energy) and investment style (normally growth or income).

There are also funds that invest in other funds, called multi-manager or fund of funds which rather than investing directly into individual assets, invest in other collective investments in the hope that specialist managers in the various asset classes will deliver market beating performance.

Fund charges

Previously, investors in unit trusts and OEICs faced two charges – an initial fee, and an annual management charge.

At around 5% the initial fee was often discounted by the fund ‘supermarkets’; the annual management charge (AMC) was typically 1.5%, but with the addition of admin, legal and custodian fees, the total annual cost of a fund was often much higher, quoted as the total expense ratio or TER.

However, RDR reduced fund charges significantly; most fund groups have done away with initial charges and ongoing fees have typically reduced by half.

The average AMC on an actively managed fund is now around 0.75%, rising to around 0.85% with  additional expenses added to make up the full ongoing charge figure (OCF) which replaces the old TER.

Costs are a drag on performance and levied whether the fund makes money or not; if you’re paying a premium for active management it is well worth doing some homework into the funds you are considering.

Ultimately, the long term performance of your investment is dependent upon the decisions that the manager of the fund or funds you choose makes and you should look carefully at a fund’s risk profile before deciding to invest.