Why it can pay to invest in funds

Many newcomers to equity investment are nervous about investing in individual firms – and that's where funds can help by spreading your risk. But how do you choose the right fund for you, if you can't tell an Oeic from an ETF? And how can you avoid paying expensive fund management fees? Let MoneyWeek be your guide to the world of collective investments...

Many newcomers to equity investment are nervous about investing in individual firms – and with good reason. Putting all your money into a few stocks is a high-risk strategy, especially for the inexperienced, because it leaves you vulnerable to sharp fluctuations in the share price of the individual stocks you pick, not the markets in which they trade. If you get it right and pick winners, great. But if you pick a couple of big losers, your whole portfolio will be scuppered. Collective, or pooled, investments can diversify your holdings and therefore reduce that risk.

Why pooled funds?

Unit trusts, open-ended investment companies (Oeics, pronounced oiks) and investment trusts are all vehicles that let you pool your money with lots of other retail or small investors. (In the US, this kind of investment is known as a mutual fund.) The pooled money is then invested on your behalf in a wide range of different equities by specialist fund managers. (There are also funds that invest in bonds or other assets, such as commercial property or commodities.) The fund manager takes a fee to run the fund and research what stocks to buy.

If they get it right, it means you get access to a highly diversified range of stocks at a reasonable cost. It also gives you easy access to asset classes and international markets that would otherwise be difficult and/or expensive to invest in. For example, specialist funds are available that invest only in Japan, or Latin America, or only in technology firms, and so on. Also, different funds are designed to meet different investment objectives and there's a wide range to choose from. Some aim for income, some for capital growth, and some for a balance of the two.

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Unit trusts and Oeics

Until recently, unit trusts were the main kind of collective retail investment in the UK. With a unit trust, you buy a fixed number of units in a fund, which then rise and fall according to the value of the underlying assets the trust invests in. Over the past few years, many fund managers have converted their unit trusts into Oeics in the belief that investors find them simpler to understand. From the point of view of the investor, Oeics are more or less the same as unit trusts; they are open-ended in the sense that (like unit trusts) the fund's size expands and contracts depending on investor demand. The big difference is that Oeics have only one price (as opposed to the dual bid/offer pricing of unit trusts).

Investment trusts

Like Oeics, investment trusts are firms whose business is to invest in the shares of other companies. But unlike unit trusts and Oeics, investment trusts are closed-ended': there are a fixed number of shares in issue, which are traded on the stock exchange. The purpose of an investment trust is, broadly speaking, the same as an Oeic to give smaller investors cheap access to a wide range of shares. But they are structured rather differently.

The fact that investment trust shares are traded on the open market (the London Stock Exchange) means the share price is determined not just by the value of the trust's underlying assets, but by current market demand for its shares. Sometimes, if an investment trust is popular, it will trade at a premium to its net asset value (NAV). Other times, it will be trading at a discount.

Investment trusts can borrow money (called "gearing"), often up to 10%-15% of the value of assets and use it to invest in the markets. This is great if the markets go up, but of course the funds losses escalate if they fall.

The final significant difference is that investment trusts are cheaper to buy than unit trusts or Oeics. Actively managed unit trusts have upfront fees of anything up to 5%-6% of the investment, plus an annual management fee of around 1.5%. By contrast, charges on investment trusts are typically less than 1%. However, they are not so cheap for regular investors as most brokers charged the same dealing fee as for regular company shares.

Passive or active?

One way of minimising the cost is to go for an index-tracking fund. These funds aim to match or track' the performance of a given market index, such as the FTSE All-Share or the FTSE 100. They do this using computer programs to work out how much of each individual stock they need to buy and sell to mimic the performance of the index as a whole.

That's much cheaper than employing lots of expensive experts' and researchers, so index-trackers are much cheaper than actively-managed' funds. Index-trackers might seem like a safety-first option, but there's a great deal of research evidence to suggest that they outperform most actively managed funds over the long-run because their charges are so low (typically 0.5%, or even less).

Another good passive form of pooled investment is the exchange-traded fund (ETF). These work like index-trackers, in that they target a particular market or sector index, but are traded as shares, allowing for cheap and highly flexible investment.

Where do I find out more?

For a very clear overview of unit trusts, Oeics and investment trusts, see www.incademy.com/courses. This useful site explains in detail how pooled funds operate, with advice on everything from fees to tax, to the best way to buy. Probably the two best sites for researching potential funds to invest in and comparing the performance of different funds and sectors are www.trustnet.com and www.citywire.co.uk. For information on ETFs, see www.ishares.net or www.etfguide.com.