What you need to know about investing in 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 of us don't want to pick individual shares and bonds ourselves, so we get others to do the work for us by buying investment funds. You and, say, 999 other people, stump up £100 each. The managers of the new fund collect this £100,000 and invest it. If in two years' time the £100,000 is worth £110,000, your unit of (or share in) the fund will be worth not £100, but £110. If you wish, you can sell that share either in the market, or to the managers of the trust, who will sell it to someone else.

The first such scheme was set up in the UK by London-based solicitor Philip Rose in 1868, when stock investment was largely closed to all but the very wealthy. Rose wanted to provide a vehicle for the ordinary investor to put his capital to work in a fully diversified portfolio. Today, 99,000 investors still have money in his fund now known as the Foreign & Colonial Investment Trust.

The main types of fund in the UK

The oldest type of fund in the UK is the investment trust. An investment trust is a listed company with shares that trade on the stockmarket, just like those of any other company. The difference is that its business is to invest in the shares of other companies. Investment trusts are referred to as "closed-end" because the number of shares (or units) into which the 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 market.

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More common today are a second kind of fund, open-ended funds (such as unit trusts). The amount of money in each of these is variable, rising and falling as investors buy and sell. If new investors want to buy in, the manager creates new units for them, and invests the new money to increase the overall size of the fund's portfolio. To invest in a unit trust you need to go via the fund manager, a financial adviser or a fund supermarket.

Finally, there are exchange-traded funds, passive funds that track an index, which are traded on the stock exchange in the same way as shares.

Why we like investment trusts

Given the choice between these, I'd take an investment trust any day. Firstly, as well as using the money from investors, they can also borrow to invest. This means they can make more in good times (as long as the overall returns from investing the money are greater than the cost of borrowing it), although it also means they can lose more in bad times.

Secondly, the money inside an investment trust is "permanent capital". Once it has been raised, it stays in the fund. This means that the fund manager doesn't have to worry about inflows and outflows, which means he can take a longer-term view than the manager of an open-ended fund. So he can invest in illiquid assets (those that are hard to buy and sell, such as very small or even unlisted companies), knowing that a grumpy investor can't demand that he sell them before they come good. Thirdly, investment trust shares, like those in any other company, can trade at a discount to net asset value (NAV).

Finally, investment trusts don't have to pay out all the dividends they get in to their investors as income every year. The can hang on to them and pay them over a longer period, to smooth the income investors get. They can even pay income to their investors out of capital should their directors think it a good idea. This might not be what everyone wants, but for those trying to figure out how to make pensions freedom work for them, it could be useful.

Costs matter – a lot

One final reason to look at investment trusts is cost. Closed-end funds used to be cheaper than open-ended, because financial advisers were paid no commission on the former. That isn't the case any more (no commission is paid on either). But depending on the broker you use, you should still find that the cost of the big trusts is pretty low. This matters.

The odd 1% may not be seem much, but it makes a big difference over time: £10,000 invested in a fund that grows at 7% a year would be worth £14,000 in five years if you paid no charges at all. Charges at 1% would reduce it to £13,338; and at 2%, it falls to just over £12,667. Over ten years the gap widens. At 0%, the money is worth £19,670; at 1%, £17,790; and at 2%, just £16,070 – more than £3,000 will have been moved from your pocket to that of a financial services firm.

The good news is that fees are coming down. According to the FCA, the average cost of an actively managed fund in the UK has fallen from 1.07% in 2015 to 0.8% in 2019. Passive-fund fees fell from 0.25% to 0.11% in the same period.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.