What you need to know about investing in funds

There are no sure things in investing. The one variable you have absolute control over is the amount you pay for an investment.

That's why we favour “passive” investing, which is cheap, over “active” investing, which tends to be more expensive. We have discussed this in detail before: What you need to know about funds.

So is it ever worth paying for a fund manager to pick and choose stocks for you? The answer is yes but you need to buy the right type of fund.

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There's one type of actively managed fund that, unlike the majority of actively-run funds, frequently manages to beat the wider market. Here I'll explain exactly what they are and how you can find the right one for you.

Unit trusts versus investment trusts?

Actively-run funds come in two main types: unit trusts and investment trusts.

With these schemes you – along with other people – give your money to a fund manager who then invests it in a portfolio of investments. These are usually the shares or bonds of companies quoted on the stock exchange, government bonds, property or cash.

Unit trusts are known as open-ended schemes. This is because the manager of the fund can issue new units when more people want to invest. The value of a unit trust is always the value of the fund divided by the number of units. So if the value of investments is £1m and there are one million units in issue, the unit price is £1.

Investment trusts are slightly different. They are closed-end schemes. Here the amount of money invested in the fund is usually fixed when it starts up. New shares are not issued when more people want to invest. Instead the shares are traded on the stock exchange.

This means that if you want to put your money into an investment trust, you have to buy its shares through your stockbroker. It also means that the price of the shares rises or falls in line with demand for them.

As a result, the value of an investment trust will not always equal the value of its underlying investments (its net asset value, or NAV) divided by the number of shares. Sometimes the shares are worth more: they are said to be trading at a premium to NAV. Sometimes they are worth less and trade at a discount.

Unlike a unit trust, an investment trust can borrow money to invest. This can help boost investment returns when markets go up but it also increases losses when markets go down. This means that investment trusts that borrow more money can be riskier investments than those that don't.

Unit trusts are far more popular than investment trusts in terms of the amount of money put into them by private investors. Yet we prefer investment trusts, because study after study shows that they not only beat unit trusts regularly over the long run, but they also frequently outperform the market.

The only reason to pay up for active management is if you are going to get a market-beating return. Data suggest that your average investment trust has a far better chance of doing this than your typical unit trust.

But this doesn't mean you can just pick any old investment trust. You still need to put in the legwork to find a decent one. Here's what you need to look for.

Beware high fees

High costs are the enemy of the private investor. High charges make you poorer. Over an investing lifetime they can take a large chunk out of your savings.

So you need to look at how much the investment trust is charging you. This is not always as easy to find out as you might think. Unit trusts typically have an annual management fee of around 1.5% of the value of your investment. Total expense ratios (TERs), which include some other costs, are typically around 1.7%.

But this is far from the total' price. It excludes things like the cost of buying and selling shares and other running costs. So when everything is taken into account, the cost of holding a typical unit trust is probably just over 2% of your fund value each year.

The good news about investment trusts is that they are usually a lot cheaper. The main reason for this is that they don't pay commissions to financial advisers to promote their funds. This commission accounts for around 0.75% of the total unit trust fee.

TERs for investment trusts also include items such as the costs of buying and selling shares. They are therefore a truer reflection of the actual cost to you. However, you should also be aware that the TER excludes the interest payments on any borrowed money. This will reduce your returns too. It's another reason to be particularly careful if you are buying a geared investment trust one that invests with borrowed money.

We think that you should pay no more than 1% a year for a very good investment trust without borrowings. Ideally you should pay less than 0.75%.

Also check to see if the fund charges performance fees. These are sometimes payable if the fund beats a particular target, such as growing the fund value by 5% more than the market as a whole.

Sometimes these fees are ridiculously high. You need to find out if the targets are too easy and what time period they are based on. All this information can be found in the trust's annual report.

Generally speaking, you should avoid trusts that charge performance fees. Too often it leads to the manager getting very rich at your expense. For example, I've never heard of managers giving investors something back if they lose money.

Finally, have a look to see if the charges are based on the NAV or the share price of the investment trust. If the share price is different to the NAV, this can make a difference to the fee that you pay.

What does it invest in?

As well as the charges, there are a number of other aspects of investment trusts to look at before you take the plunge.

For a start, if you are going to pay a fund manager to look after your money, make sure they are actually doing something useful for you. Have a look at what they are investing in and how they invest. You can find this out by reading the trust's annual report or monthly factsheets. Both of these should be on the trust's website.

Too many funds just try and mimic the stock market. For example, if a UK equity fund has big holdings in shares such as Shell, HSBC and Vodafone, you might be invested in something known as a 'closet tracker'. These funds are a waste of your money. You can buy an index-tracking fund with much the same holdings for a lot less.

Is the manager any good?

Sometimes fund managers are just lucky. But a manager with a consistent track record of making money for investors is usually a good sign. Again the annual report should give you lots of information on this. You can also find information about managers' track records on specialised websites such as trustnet.com or morningstar.co.uk.

It's worth checking if the manager and directors of the investment trust have a significant stake in the trust. After all, if they are not prepared to risk a meaningful amount of their own money in the trust they are running, why should you? We'd look for shareholdings at least equivalent to their annual salaries.

Premiums and discounts

As mentioned above, because investment trusts trade on the stock exchange, they don't always reflect the underlying value of their assets. There are lots of reasons why this happens.

Trusts can trade at a premium to NAV because investors are very optimistic about the future. This can mean that the trust's shares go up faster than the value of the investments that it holds. A high-profile fund manager can also sometimes command a premium.

It's also possible that the trust's assets could be undervalued. This can happen if it is invested in things like property or unlisted investments where the investments change hands less regularly than listed shares, and so are less easy to value.

Buying a trust for more than its assets is usually not a good idea. Premiums can quickly become discounts and you can end up losing money.

Discounts happen for the opposite reasons to premiums. Pessimistic investors,managers that aren't very good, and unfashionable investments are the main reasons for them.

But sometimes buying trusts at a discount can net you a bargain. Trusts trading at big discounts can be taken over. Or market sentiment may improve and reduce the discount. These are the sorts of trusts that you should be looking to buy.

Some investment trusts these days use what is known as a no discount policy. What this means is that the trust tries to make sure that the share price is always at or around the NAV.

So when the shares trade at a discount, the trust buys shares in the market to push up the price. If the shares trade at a premium, it will issue new shares on the stock exchange to push the value per share down towards its NAV. Investors in these trusts can therefore be confident that their shares are fairly valued.

We like investment trusts here at MoneyWeek magazine. By knowing how to pick a good one, you can go and find the right one for you. However, if you're feeling lazy, we also have picked out a core portfolio of investment trusts that we believe are solid bets for anyone. You can read all about the portfolio here: The MoneyWeek model portfolio.