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.

Fund managers cost money. So the only point of employing one is to get a better return than you would from just buying the market.

Yet most fund managers don't beat the market, certainly not regularly enough to justify the extra expense of employing them to manage your money.

After the layers of costs have been taken away, most people's savings end up being lower than if they had invested in a basket of low-cost index tracking funds.

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That's why we usually recommend that investors find cheap asset classes, then invest in them using index funds.

But is it ever possible to find a decent manager who has a shot at delivering what they promise market-beating returns? Or what if you are investing in a more exotic area, where it's hard to find a decent index tracker?

How do you go about finding someone who's going to look after your money and grow it?

There are lots of fund research websites out there, such as morningstar.co.uk, trustnet.com and citywire.co.uk. These spend a lot of time rating funds, and once you've located a promising fund, you can find a lot of useful data on these sites.

But given the number of funds out there, where do you start?

Your broker might have a list of the latest hot funds on its website. But don't forget, until 1 January 2013, brokers can earn good money by selling funds to their customers and so will not be shy in promoting them.

1. Avoid the big boys

A better bet is to start looking for gems among the smaller fund management groups. Known as boutiques', they can often be better homes for your money than the big asset management firms run by banks or big insurers.

Why? Because although they won't admit it, for these bigger firms, performance is not the priority. They would prefer to use their marketing clout to gather customers' assets and hang on to them. The more assets a manager can gather, the bigger the annual management fee (1% of £1bn is a lot bigger than 1% of £1m).

These companies also understand that people are apathetic when it comes to managing their money. So as long as the investment performance isn't too atrocious (and sometimes even when it is), these firms can rely on hanging on to most of these assets.

This means that a lot of the so-called active' funds at these places tend to be what are known as closet trackers'. As long as the performance doesn't stray too far from the index they are comparing themselves against, they hope that customers won't complain too much.

The attraction of investing with smaller fund companies is that the fund managers often have a significant stake in the business themselves. So without a good investment performance, their livelihood is at stake. They are also free from the layers of bureaucracy and hordes of unit trust sales people badgering them about this week's performance that you tend to find at bigger asset managers.

So these boutiques are a good starting point for finding decent managers and funds.

2. Does the manager eat his own cooking?

What should you look for next? Well, don't even consider investing with a fund manager unless they have a meaningful amount of their own money invested in their funds.

Having worked in the fund management business myself, I can tell you that lots of managers don't. Some are very happy to take the big salaries and bonuses, but they wouldn't touch their own fund. Often they think it's too risky, or poor value for money. And they're probably right.

But the good news is that there are plenty of honourable managers, who do invest alongside their customers. It's not always easy to find out just what sort of stake the manager holds, but it's worth doing the digging. After all, if you're going to invest in a fund, then you really want to think about putting your money with people whose interests are aligned with yours.

3. Look for small funds rather than big ones

Smaller funds are more nimble. Because they are not investing large amounts of money, they can buy under-researched, smaller investments without moving the price of them too much. This means they have a better chance of making money and beating the market.

Bigger funds are harder to manage. They have to buy larger, more mainstream investments that more people know about, which means that these funds find it difficult to add value to their customers.

This means it's also an encouraging sign when fund companies limit the size of their funds. It's a big temptation for managers to just keep bringing the money in and boosting the annual fees. But by doing this, you increase the danger that you sacrifice performance in favour of asset-gathering.

So managers and companies who resist this are clearly putting their clients first always a good sign.

4. How long will the manager stay with the fund?

This is one of the biggest problems with active funds.

You might find a good manager who does well for a few years. But a rival firm then comes along and dangles the promise of big money in front of them and they leave.

Should you sell up and incur buying and selling costs and move with them? Or take your chance with the new manager of your money? Not all managers do as well with their new employers. But not all new managers perform as well as their predecessors. So whichever decision you make, you're taking a gamble.

You might be able to avoid the chances of this risk arising by investing with a manager-owned fund company, or a fund that has a team of managers, so that succession is less of an issue.

5. Can the manager hold cash?

It's no good having your money in an active fund if the market crashes. Too many funds stay fully invested all the time. They often justify this by saying that customers pay them to manage an asset class for them, and so they need to be invested in it.

This may be true. But I've always struggled with this argument. Customers should not be paying fund managers to lose them money, even if they fall by less than the market. It's always worth remembering that an asset that loses half its value needs to double just to get you back to where you were.

A good fund manager will protect your money by turning investments into cash when they think a market is expensive. This means they are well placed to take advantage of cheap investments after they have fallen in value.

But how can you identify these managers?

Before you buy any fund, go back and look at how a manager has performed in bad markets. For example, check how they survived during 2008.

Often you'll find that they did increase their cash holdings but only after the market had crashed, and not before. That's no good to you.

This is why we prefer passive' investing

The trouble is, asking and answering these questions can take a long time. Even if you do this, trying to find a good manager who is good value for money is very difficult. For most private investors, the truth is that we don't think the search is worthwhile.

With the large selection of cheap exchange traded funds (ETFs) out there, and a bit of legwork, we think you can manage your own money just as well, and it'll cost you a lot less too.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John 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. John joined MoneyWeek in 2005.

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.