What you need to know about investing in funds

When it comes to picking a fund, many investors just focus on what that fund invests in or who the manager is. The structure of a fund (whether it's an investment trust or a unit trust, for example) often doesn't seem too important. But there are major differences between these types of funds, and understanding them could potentially save you a lot of money. So it's worth getting to grips with the technicalities.

Unit trusts and Oeics

There are three main types of funds in Britain. The first are open-ended funds, often called 'unit trusts', although now many are a more modern form called open-ended investment companies (OEICs) or investment companies with variable capital (ICVCs). These are split into units or shares whose value is directly tied to the fund's net asset value (NAV the value of the assets the fund holds). When you invest in one of these funds, your money goes to the manager, who creates new units to be issued to you. When you want to withdraw, you sell your units back to the fund to be cancelled. Because the price at which units are created and redeemed is tied to the fund's net asset value, demand for the fund has no effect on the value of units held by existing investors. Although heavy selling of units could cause the fund liquidity problems.

When you invest in an open-ended fund, you will usually be charged an entry fee, often as much as 5%. With an OEIC, this will be charged as a separate commission. With unit trusts it takes the form of a spread between the offer price (at which you can invest) and the bid price (at which you can redeem) this is the only obvious difference between the two types. The fund will also charge an annual management fee. This varies from around 0.5% a year for a passively managed fund (which tracks an index) to up to 2.5% a year or so for some actively managed ones (where the manager tries to beat the market). Some funds also charge exit fees. Performance fees (say 20% of all gains over 10% per year) are sometimes added, usually by niche funds from specialist providers with a strong track record.

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Funds can be bought direct from the provider, via a financial adviser, or through a broker. The big discount brokers, known as 'fund supermarkets', can often secure discounts on fees by virtue of their purchasing power, so you should always check these before buying.

Investment trusts

The second type are closed-end funds, known in Britain as investment trusts. These have a fixed amount of capital initially invested in the fund and a fixed number of shares outstanding. When you invest in one, you simply buy shares from an existing shareholder and the money goes to them, not into the fund. The shares trade on a stock exchange, with the price determined by market demand. In other words, the value of the shares isn't directly tied to the value of the assets the fund owns. As a result, shares can trade at a premium or discount to the net asset value, depending on how popular the fund is. A small discount is normal. A large discount could either mean an overlooked bargain or that investors have doubts about the fund's management or the assets it owns. A premium points to high enthusiasm for the sector or the manager's skill. Generally, you should avoid buying at a premium.

Investment trusts are bought and sold through a stockbroker. There are no entry or exit fees, but you will have to pay the same broker commissions as you would when trading any other share. As for management fees, these vary. Most investment trusts charge 1%-2% of assets per year; again, a few will also charge a performance fee.

Exchange-traded funds

Finally, we have exchange-traded funds (ETFs), which behave like a cross between open-ended and closed-end funds. They trade on a stock exchange and are bought through a stockbroker. However, the price at which you buy and sell usually stays very close to the net asset value. This is achieved by having 'authorised participants' who trade directly with the fund to arbitrage away any difference between the price of an ETF unit and the value of the assets the ETF holds. ETFs are usually passively managed and track an index of shares or the price of a commodity. They're designed to be low-cost investments; total expense ratios (fees plus costs) may be as low as 0.1% a year.

Which type is best?

Low cost and convenience means ETFs are better than traditional unit trusts if you're looking for a tracker. For actively managed funds, the choice between unit trusts and investment trusts is more complex. Open-ended funds are more popular with the fund industry because they serve its interests better. But as long as fees and manager quality are the same, there are two reasons why investment trusts can be a better deal for investors.

First, there's often the opportunity to pick up an out-of-favour investment trust at a large discount to its asset value. The discount will usually close if the fund produces good returns, increasing your profits further. Second, there's often a better match between managers' and investors' incentives with investment trusts.

Too many 'actively managed' funds secretly track the market because the manager's survival instinct takes over: it's less dangerous to your career to perform in line with the market than take big contrarian calls and risk underperforming while waiting for them to come good. This is especially true of open-ended funds, which are very exposed to the risk of investors pulling money out of the fund when they lag the market. As investment trusts are closed they're partially protected from this and may be able to take a longer-term view.