Investing Basics: What are Mutual Funds?

 

A mutual fund is a type of collective investment that pools investors’ money to buy and sell shares or other assets in a range of companies to maximise profits and reduce risks – writes Christian Leeming

 

Different types of fund are Unit Trusts, Open Ended Investment Companies (OEICs) and Investment Trusts and they may concentrate on a particular market, asset class or sector.

This will be reflected in the underlying investments a fund makes and in the level of risk associated with a particular fund.

 

How Does it Work?

 

When you invest in a unit trust, your money buys a number of units that represent your share of the overall value of the trust. New units are created whenever new investments are made into the fund and cancelled when you sell your units back to the unit trust manager. The total number of units will therefore vary.

Once a day, the fund manager will calculate the total value of the underlying investments (net asset value or NAV) and from this value establishes the price a new investor has to pay for units, i.e. the ‘offer’ price; the price directly reflects the value of the assets held by the fund.

The ‘bid’ price is the price you will be able to achieve when you sell your units back to the fund manager. The difference between the offer price and the bid price is called the ‘spread’ and is used by the unit trust manager to cover fund administration and management charges.

OEICs operate in a similar way to unit trusts except that the fund is run as a company and creates and cancels shares rather than units when investors come and go.

Investment decisions are made by one or more fund managers who regularly increase or decrease their positions in companies depending on their view of the world.

This is the ‘active management’ for which you have to pay a fee to the fund for – which is built into the product pricing.

 

How are Unit Trusts Prices set?

 

Although there are no restrictions on when you can buy or sell units, the latest unit trust prices are always fixed so that the cost to buy units is higher than the sell price at all times.

These prices, the ‘offer’ price and ‘bid’ price respectively, are based on the current value of each fund. As such, unit trust daily prices rise or fall based on the fund’s growth, with the best performing unit trusts usually ‘offering’ higher prices.

 

What are the Benefits?

 

By pooling your investment with other investors’, you can invest in a more diversified portfolio than you might be able to on your own and thus spread the risk and increase your chances of making a profit.

If you have £10,000 to invest, it might be difficult to achieve a diversified portfolio without incurring high transaction costs.

‘By pooling your investment with other investors’, you can invest in a more diversified portfolio’

However, if 1,000 people each invested £10,000, the total fund available to invest would be £10 million. A large fund can make investments that individual investors may not be able to make and transaction costs will also be lower if one large investment is made instead of several small ones.

Many funds are specialists in regions, such as South America, themes such as energy or picking high-yielding assets like certain bonds or stocks.

Thus it is possible for you to find products with the market exposure and risk profile you want for your portfolio.

You will also benefit from the unit trust’s professional fund managers. Instead of having to research and analyse every individual company’s shares you might want to buy, a professional fund manager with the relevant investment expertise and knowledge will do this on your behalf.

Funds managers are ‘institutional investors’ and may get preferential access to fundraisings which means they are first in line to buy shares when companies look to raise money to expand – often at a discount to the market price.

Because they may have large holdings in a particular company the fund manager may have greater influence over its strategy than an individual share holder.

Fund managers may also be expert in other asset classes such as bonds or commodities, which may be added to a fund’s holdings.

Most funds allow investors to drip-feed their money into a fund. If you have only £50 to invest each month, by investing in a unit trust, you will still be able to gain exposure to the stock market.

If the underlying investments of the unit trust perform well, the value of the fund will rise and the value of your individual units will rise, too.

You can also receive “distributions”, i.e. your portion of the dividend income the unit trust has received from its assets. The value of your distributions depends on the number of units you hold.

Distributions can be monthly, quarterly or every six months, depending on the type of fund that you invest and are derived from the dividend payments received by the fund from the underlying shares in which they invest, or interest payments from bonds or even rental income in the case of property.

‘There are over 2,000 different unit trusts and OEICs available to investors in the UK’

Most unit trusts and OEICs will give you two options to choose from for payment – income or accumulation. Income units pay the distributions as income, while accumulation units wrap up those distributions and reinvest them in the fund, to increase the capital value of your investment.

While income payments, or the compounding of income within a fund through accumulation units, is often a major attraction for fund investors, most will also be looking for some capital growth in the long term. So fund managers will also invest with a view to growing the value of their assets over time, sometimes more aggressively in the case of growth funds.

 

Where can Unit Trusts and OEICs Invest?

 

There are over 2,000 different unit trusts and OEICs available to investors in the UK, investing in over 30 sectors.

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).
Unit trusts and OEICs no longer invest simply in one asset, sector or region – the IA lists three sectors of managed funds:

 

• Mixed investment 0-35% shares
• Mixed investment 20-60% shares
• Mixed investment 40-85% shares

 

which invest in multiple assets to provide investors with a diversified portfolio housed within one fund.

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

 

In the past investors in unit trusts and OEICs faced two charges – an initial fee, and an annual management charge.
 
In unit trusts, the initial fee, often around 5%, was the spread between the bid and offer prices on the day of purchase and with just one price OEICs simply charged a percentage of the overall investment.
 
In addition, actively managed funds typically charged around 1.5% as an annual management charge (AMC), but with the addition of admin, legal and custodian fees, the total annual cost of a fund was often be much higher than the AMC which was quoted as the total expense ratio or TER.

However, the government’s 2012 Retail Distribution Review introduced new rules banning commission from fund charges being paid to financial advisers and brokers, which has reduced fund charges significantly.

Most fund groups have done away with initial charges and ongoing charges have typically reduced by half.
The average AMC on an actively managed fund is now around 0.75%, rising to around 0.85% when the additional expenses are added to make up the full ongoing charge figure (OCF) which replaces the old TER.

Tracker or index funds, which never paid much commission anyway, remain cheaper in most cases, with some charging less than 0.1% in ongoing charges.

 

The impact of fund charges

 

‘costs have been found to be the biggest drag on performance in investment funds’

The numbers may seem small, but costs have been found to be the biggest drag on performance in investment funds.

The argument for the higher costs is that you’re paying a premium for the expertise and better performance that a professional fund manager can offer, but the charges are still levied, even if your manager has returned less than the market or, indeed, lost you money.

 

What are the Risks?

 

As with all investments, the value of your investment may go down and you may lose some or all of your money.

You can try to minimise the risks by looking carefully at a fund’s risk profile before deciding to invest. A fund that invests solely in FTSE100 companies will have a lower risk profile than a fund that invests in start-up companies.

Ultimately, the long term performance of your investment is dependent upon the decisions that the manager of the fund or funds you choose makes.