Beginners' Guides

What you need to know about funds

One of the most basic investment products is the fund. John Stepek explains the basics of funds, including the difference between active and passive funds, and when you should choose one over the other.

Most people over a certain age feel reasonably comfortable with financial products such as mortgages, or car insurance.

Yet mention investing, and you'll get a look of panic. Or they'll shrug and say, "I leave that to my financial adviser".

However, there's one investment product that almost everyone has encountered: the fund.

Advertisement - Article continues below

The idea behind a fund is simple. You pool your money with a lot of other investors, and give that money to someone else to manage.

The key benefit is that you get exposure to a wider range of assets than you could as an individual investor. Unless you have a very large lump sum to start off with, then building a portfolio of, say, 20 to 30 shares, could take a while.

If you buy a fund instead, you are immediately investing in a ready-made portfolio, without the hassle, time and cost of building your own.

Sounds good. And there's no doubt that funds can be useful tools. But there are a few things you need to understand first.

The big question: passive or active?

There are lots of different funds around, covering all areas of the market.

But the most basic distinction between fund types boils down to one question. Do you want to track the underlying market, or do you want to try to beat it?

Advertisement - Article continues below
Advertisement - Article continues below

A passive' fund also known as a tracker fund merely tries to copy the performance of the underlying market. The underlying market could be the FTSE 100, an index of Japanese shares, or even the price of gold.

Whatever it is, all the passive' fund aims to do is to match it. It goes up when the market goes up, and goes down when it goes down. That's why it's called a passive' fund.

Active' funds, on the other hand, employ a fund manager, who aims to beat the underlying market, by using their investment skills to pick and choose different assets.

If the market rises, the active' fund should rise by more. If the market falls, the active' fund might fall too, but not by as much.

So which should you opt for?

So far, this might sound like a stupid question. Who wants to track the market when you can beat it? Isn't an active' fund the obvious choice?

Advertisement - Article continues below

It would be, if active fund managers could guarantee to beat the market. Problem is they can't. Far from it. The truth is that most managers fail to beat their benchmark (the market they are pitted against) over the long run.

In fact, most struggle even over the short term. For example, roughly two thirds of managers failed to beat the market in 2011, according to Citywire.

The problem with active funds

The biggest problem with active funds is not necessarily that fund managers are bad at investing on the whole. Indeed, some studies suggest that overall, fund managers are better than most people at picking stocks (as you'd have hoped!)

The big problem is costs. A typical actively-managed fund charges you 1.5% of the amount you've invested each year. A typical tracker fund will charge less than 0.5%.

Advertisement - Article continues below

You might already be seeing the problem here. To have any hope of beating the market, the fund manager has to make enough money both to beat the market, and to pay for their own costs.

Advertisement - Article continues below

That might not sound like much, but a simple example might put it into perspective. Say you invest £100,000 at 1.5%, then leave it for 20 years.

Let's assume that it grows at the (somewhat optimistic) rate of 7% a year. By the end of 20 years, you have around £290,000.

Now take the same investment, and the same returns, but cut the fee to 0.5%. After 20 years, you've got around £350,000.

That's a huge difference.

Are active funds ever worth it?

This argument seems to make the case for passive funds very strong. And that's because it is. Yes, tracker funds do have some problems, and we'll look at those in more detail in the future.

But logically speaking, if you have no real idea of whether your active' manager can actually beat the market, then it makes far more sense to buy a fund that will at least track your chosen market.

There are times when it can be worth paying the extra for active management. You may not always be able to find a passive fund that tracks the sector you are interested in. Or you may have found a fund manager with a consistent strategy and a good track record that you are happy to invest with.

But the point is that active funds are expensive compared to passive funds. So if you are going to go down that route, you should make sure that they are worth it.

What you should do now

Look at your current portfolio. If you have any funds, are they actively managed or passively run? If they are actively managed, then how does the performance compare to the benchmark index? Are they worth the fees, or would you have been better off just tracking the market?

Follow John on Twitter||Google+ John Stepek

This article is taken from our beginners' guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here .




Precious metals will keep shining – buy these funds to take advantage

Data on volatility suggests that a V-shaped recovery may not happen, so hold gold or silver.
1 Jun 2020
Investment strategy

How income from options could prove illusory

Funds that use call options to supplement dividends can offer higher yields, but this usually comes at the cost of lower long-term returns.
1 Jun 2020

Compound interest: the eighth wonder of the world

Setting up a pharmaceuticals trust in the mid-1990s taught Max King the power of compounding
26 May 2020

In support of active fund management

We’re fans of passive investing here at MoneyWeek. But active fund management has its place too, says Merryn Somerset Webb.
25 May 2020

Most Popular


Disease, rioting and mass unemployment – so why are markets soaring?

Despite some pretty strong headwinds in the last year, America’s S&P 500 stock index is close to all-time highs. John Stepek explains why markets seem…
4 Jun 2020

These seven charts show exactly why you must own gold today

Covid-19 is accelerating many trends that were already in existence. The rising gold price is one such trend. These seven charts, says Dominic Frisby,…
3 Jun 2020
EU Economy

Why a stronger euro is good news for investors

The fragile state of the eurozone has for a long time brought the threat of deflation. But the ECB’s latest moves have dampened those fears. John Step…
5 Jun 2020