15 Understanding investment funds
There are good reasons to invest in funds.
Buying shares in a single company or even holding shares in, say, three companies, can be seen as a risky form of investment. This is because the fortunes of a company, on which its dividends and share price depend, are subject to all sorts of risk. These risks can be broad economic risks, such as recession or an increase in the cost of oil, or risks specific to each company, such as the loss of a major contract or increased competition. The same applies to buying bonds issued by companies and other institutions, although the price of these is normally less volatile than shares.
To spread these risks, investors can invest in shares (and other assets, such as bonds) through investment funds. An investment fund pools the money of lots of investors and uses it to hold a wide range of shares, bonds and/or other assets. Even relatively small amounts of money placed into such funds can be spread across a wide variety of shares or other assets.
So the first things you need to be clear about when considering investing in a fund are the types of assets the fund holds and in what proportions. This is because your investment, however small, will hold these assets in equivalent proportions.
The proportions held will also determine the risk profile of the fund. Look at the three funds in the table below and the ways they are divided between different assets. Fund 1 would be usually classified as low-risk – where the risk means exposure to a fall in value. Fund 2 is medium-risk and Fund 3 is high-risk. The key determinant of the degree of risk is the proportion of the fund invested in the shares, since these are the riskiest of the three categories of assets.
Table 4 Funds and risk profiles
|Fund 1||Fund 2||Fund 3|
The investments in funds may be selected by managers, based on research which aims to assess the prospects for shares and other bonds (called ‘actively managed’ funds). Investors pay fees for the services of the fund managers and are provided with periodic reports on their investments – usually quarterly.
Other funds (called ‘passively managed’ or ‘tracker’ funds) simply hold investments designed to move in-line with a specified share index, such as the FTSE-100 – the index for the shares of the 100 largest firms listed on the London Stock Exchange. Passive funds normally have lower charges as they involve less work for the fund managers.
Investment funds come in many forms, including:
- Unit trusts: this is an arrangement whereby trustees hold shares and/or other assets on behalf of investors and a management company makes decisions about what and when to buy and sell. Investors hold units in the unit trust and the value of the units directly reflects the value of the underlying assets in the fund.
- Open-ended investment companies (OEICs): these are very similar to unit trusts but are structured as companies rather than trusts.
- Investment trusts: these are companies that are quoted and traded on the stock market. The purpose of an investment trust company is to run an investment fund. Investors buy shares in the company. The price of the shares reflects both the value of the assets in the underlying fund (called the ‘net asset value’ or NAV) and the balance between investors buying and selling the shares on the stock market.
- Exchange-traded funds (ETFs): these are also companies traded on the stock market but, in this case, the share price is directly linked to the value of the underlying investments. Traditionally, ETFs are tracker funds. This could be, for example, a FTSE-100 Index tracker or a more unusual index tracking, say, the price of commodities or works of art.
- Life insurance funds: some types of life insurance can be used as investments. The investor pays in regular premiums or a single lump sum premium, and the policy builds up a cash value that may be drawn out either as a lump sum or as a stream of income payments.
- Pension funds: Contributions may be invested in one or more underlying funds. The value of the pension scheme depends on the performance of those funds. We’ll spend more time in the next session looking at pension funds.
Investment funds can be bought directly from fund managers, through stockbrokers or through specialist websites (often called ‘platforms’).
One way that you can invest money in a fund is through Stocks and Shares ISAs. The investments you make each year must, along with any savings made into cash ISAs, not exceed the annual limit set by the government – which was £20,000 in 2020/21.
A Stocks & Shares ISA is an investment product which means that the capital you invest can rise and fall in value. When buying these ISAs, look closely at the asset combination of the fund you are buying into, to ensure that you are comfortable with the risks you are taking.
Activity 7 Being a socially responsible investor
An additional consideration for many people is a desire to invest their money in a socially responsible way.
There are different aspects to what constitutes socially responsible investment. Can you think of some positive and some negative criteria people use to identify when an investment is socially responsible?
Positive criteria can include investing in companies that treat workers fairly or are engaged in environmental protection. Examples of negative criteria include avoiding funds that invest in companies involved with fossil fuels, animal experiments, arms, violating human rights or pornography.
One difficulty for an investor is that ethical or social responsibility is a relatively subjective term. One way of checking whether a fund that claims to be ethical or socially responsible shares your own views is to check the main companies the fund invests in.