In this the second of our special two-page sections on the workings of the stockmarket MoneyWeek looks at the benefits and drawbacks of investment funds
Investment funds: What are they?
Pooled investment schemes. They work like this: you and, say, 999 others, stump up £100 each. The managers of what is to be the new fund collect the £100,000 and use it to buy other assets shares or bonds, for example. With a bit of luck, the value of those assets rises. If in two years' time the £100,000 has grown to be worth £110,000, your unit of or share in the fund will be worth not £100, but £110. You can now or at any time sell that share either in the market, or to the managers of the trust, who will sell it on to someone else.
The first of these schemes was set up in the UK by London-based solicitor Philip Rose in 1868. Back then, stockmarket investment was largely closed to all but the very wealthy. Rose wanted to provide a vehicle into which the ordinary investor could place his capital, have it invested for him and still sleep at night. So he did. Buying a holding in his fund meant buying a unit in a fully diversified portfolio. Rose's scheme is still going strong today, with 99,000 investors with money in what is now known as the Foreign & Colonial investment trust. The fund management business as a whole is now colossal. Last year, assets of the global fund-management industry reached a record $45.9trn up 40% on 2002.
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Investment funds: Are there different kinds of funds?
Yes. Two. The oldest are investment trusts (such as Foreign & Colonial). These are listed companies with shares that trade on the stockmarket just like those of any other company. The difference is that their business is to invest in the shares of other companies. Investment trusts known as closed-end mutual funds in the US are referred to as "closed end" because the number of shares or units into which the firm's portfolio is divided is limited: new money cannot be raised without a formal issue of new shares. To invest or exit, you have to buy or sell existing shares on the stockmarket. More common today are open-ended funds unit trusts or open-ended investment companies (Oeics). The investible capital of each of these is variable, rising and falling as investors buy and sell. So if new investors want to buy into the fund, the manager will create new units to sell to them. He will then invest the money they pay to increase the overall size of the fund's portfolio. The difference between a unit trust and an Oeic is simple: the latter has a single unit price, whereas the former offers you a different price, depending on whether you are buying or selling ie, there is a bid/offer spread'.
Investment funds: Which is better?
Investment trusts offer more possibilities. For starters, they can leverage returns to shareholders by borrowing extra capital to invest. This improves returns in good times (as long as the overall returns are greater than the cost of capital). Investment trusts also often trade at a discount to their net asset value (the total market value of the shares in issue is less than the total value of the fund portfolio), which can, on occasion, provide clever investors the opportunity to buy good funds at prices below their real worth. On the downside, the fact that investment trusts can leverage their assets means that they can magnify your losses when the market is falling. This is one of the reasons why unit trusts are growing in popularity in the UK. They're also growing in popularity because they tend to be much more heavily marketed than investment trusts and pay the IFAs who sell them commissions, something investment trusts don't do (when you buy them, you just buy the shares in the market).
Investment funds: Why would I buy a fund?
To gain diversified exposure to a market or asset class that would normally be out of your reach. Those with small amounts of capital should not, for example, be betting it all on the vagaries of one share in the UK market. If they buy a fund, they don't have to. But even if you have plenty of capital, a fund is of use. How many UK private investors are capable of picking their own stocks in, say, the Japanese market, if they think it is about to rise? Again, with a fund, they don't have to: stock picking becomes someone else's problem.
Investment funds: How do I choose a fund?
First, you need to decide what you want from it. Capital growth or income or both? Exposure to just the UK markets or the US and emerging Asia as well? Some bonds? Exposure to just one sector, say oil exploration or mining? There's a fund for almost everything. Morningstar.co.uk provides information on a fund's emphasis (growth or income and region) and gives portfolio breakdowns. But deciding which area to invest in is just the start of it. You also need to look at a fund's remit. Can it move into cash if markets are tumbling? And is it concentrated on a few holdings offering higher risk and potentially higher return or diversified over a large number of stocks? Finally, you need to decide on the kind of management you want.
Investment funds: What are the choices there?
Basically passive' or active'. One in four funds are passive, in that the manager does no stock picking, but simply buys the shares represented in the fund and hence tracks an index, such as the FTSE 100. These so called tracker funds' have the advantage of being cheap you are not being charged for stock-picking skills as computers do most of the work. They are also often the better choice. In the 1999 edition of financial bible A Random Walk Down Wall Street, Professor Burton Malkiel points out that, over the long term, trackers have outperformed actively managed funds by quite a margin. At the time Malkiel was writing, had you put $10,000 in a US tracker in 1969, it would be worth $311,000. The same amount put in the average active fund would be worth only $171,000. But the same is not necessarily true over every time period. Tracker investors were hit very hard by the bear market that started in 2000, for example, putting stock-picking or active management back onto the agenda.
Investment funds: How do I find an active' fund?
Finding good ones isn't easy. You should be wary of the advertisements for funds run by star managers. Hype tends to come after, not before, they get good returns. As investors often find out to their cost, past performance is little indication of future performance. You rarely see much in the way of advertisements for Japanese funds when the Nikkei is at 8,000, for example, but you do see plenty when it is at 18,000 and the sector's managers have all had a run of luck. The main point is that over the course of a career, most managers are going to have a good two or three-year run at some stage. But this can have as much to do with luck or style as skill. So instead of considering a manager's recent record, look at whether his style matches the prevailing market mood. If you think the market is going up, for example, buy the fund that did well last time the market rose, not one that came into its own as the market was falling.
Top managers tend to move around a lot and if you want to follow them, you face the cost of switching funds to do so. One way round this is to buy funds run by companies that have good retention levels Fidelity is one or ones where the managers have a stake in their own funds. Better still, look at the boutique funds, where managers often have stakes in the whole business an excellent incentive for them to get good results.
Investment funds: What speciality funds are there?
There are hundreds of different types, from the novelty (vice funds, which invest in tobacco and oil, for example), to the serious minded (socially responsible funds), as well as exchange-traded funds (ETFs), which are effectively trackers that trade as shares. One category that has been growing in popularity is hedge funds. These aim to produce an absolute return, regardless of the wider market environment, using a variety of strategies, from selling shares short to arbitraging pricing inconsistencies between markets. Minimum investments are often at the £100,000 mark and many of the better funds are closed to new investors. Funds of funds, while an expensive way to manage a portfolio (you pay two sets of fees), can give you some access.
Investment funds: Can managers really outperform?
Some can. To find them, check Citywire's Fund Inside (www.citywire.co.uk), which allocates individual returns to managers over the long term, regardless of how many times they have moved. Over the last five years, Citywire rates Patrick Evershed, who currently manages the New Star Select Opportunities Fund, David Stevenson (SVM UK Opportunities) and Anthony Bolton (Fidelity Special Situations) as the UK's three best managers.
Investment funds: How do I judge a fund?
Funds are rated on the basis of a number of criteria, such as returns against a benchmark index (the Dow Jones or FTSE 100, for example) and overall risk profile. Morningstar.co.uk provides a cost and risk-adjusted rating system for unit trusts. Trustnet (www.trustnet.com) and Standard & Poor's (www.funds-sp.com) do the same for investment trusts. S&P provides two different forms of rating: stars based on a fund's outperformance over various timescales, and A' ratings, based on the investment process and the management's consistency of performance. Both help you see how a fund is doing relative to its peer group. Of course, all this data is historic and therefore, as ever, no guarantee of future performance.
Investment funds: What do funds cost?
Most of the time, too much. Even in the great bull market of the 1990s, many funds were achieving much lower returns than the main indices. Yet the costs were huge. One reason for this is the vast and out-of-proportion salaries paid to fund managers (again due to the bull market), but new regulations have also pushed up costs. Some open-ended funds charge as much as 5% in initial fees and 1.5%-plus in annual management fees. On the whole, investment trusts have lower charges than unit trusts. The odd 1% here and there makes a big difference. A fund that returns 10% a year after charges for 20 years will give you 24% more as a final sum than a fund that returns 8.5%. Initial charges can make a heavy impact, especially if you switch between funds every few years. The Key Features' document you get when you apply to buy an open-ended fund will detail all the charges. You should read it carefully.
Wise investors will buy funds through fund supermarkets such as Interactive Investor (www.iii.co.uk/funds), American Express(www.sharepeople.com), or Squaregain (www.squaregain.co.uk). And you should be able to get rid of the initial fee completely by taking this route. Note that while there is no initial fee for an investment trust (you are simply buying shares), there is, as with all shares, a bid/offer spread and you will pay normal share-trading commission as well.
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