What you need to know about investing in funds

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.

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.

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The big question: passive funds or active funds?

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? 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? 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.

The problem with active funds

The biggest problem with active funds is not necessarily that fund managers are bad at investing. 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%.

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. 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. 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?