Understanding Fund Investments: Where To Start And How

Investment funds are a type of financial product that pools capital from multiple investors to purchase a portfolio of various securities, such as stocks and bonds. This is usually done with the goal of earning higher returns than those offered by traditional investments. The fund is managed by a professional fund manager who makes investment decisions on behalf of the investors. Investment funds provide investors with a diversified investment portfolio that might help reduce risk and increase returns. However, like every other financial product, they also come with risks, including the potential for losses and exposure to market fluctuations.

Investment fund types

Investment funds are a way of investing money with other investors to benefit from the advantages of working as a group, such as reducing investment risk and transaction costs. There are several types of investment funds, including mutual funds, exchange-traded funds (ETFs), money market funds, and hedge funds.

Mutual Funds

Mutual funds are investment vehicles that pool money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities. They are typically categorized by the types of securities they invest in, their investment objectives, and the returns they seek. Mutual funds can be actively managed, where portfolio managers select investments aiming to outperform a benchmark, or passively managed, where managers mimic a specific index. Examples include equity funds, bond funds, and target-date funds.

Exchange-Traded Funds (ETFs)

ETFs are similar to mutual funds but trade on stock exchanges like regular stocks. They combine characteristics of both closed-end and open-end funds, offering more flexibility and intraday trading. ETFs typically have lower expense ratios than mutual funds.

Money Market Funds

Money market funds invest in high-quality, short-term debt instruments and cash equivalents, such as government Treasury bills. They offer better returns than savings accounts but are not insured by the FDIC.

Hedge Funds

Hedge funds are actively managed funds available to accredited investors. They face less federal regulation and can invest in a wider range of asset classes using various strategies. Hedge funds often invest in riskier assets, including derivatives, and may use leverage to increase potential gains and risk.

Other Types of Investment Funds

Other types of investment funds include unit trusts, open-ended investment companies (OEICs), and investment trusts. Unit trusts are governed by trust law, while OEICs are established as companies. Investment trusts, on the other hand, are structured as public limited companies and are listed on the stock market.

Investment fund advantages

Investment funds are a way of investing money with other investors to benefit from the advantages of working as a group. Here are some key advantages:

Diversification and Risk Reduction

Investment funds allow investors to diversify their portfolios and reduce risk. By pooling money together, investors can access a wider range of underlying investments and spread their capital across various assets, industries, and markets. This diversification lowers the chances of losing money due to adverse market changes or the performance of a specific security.

Professional Management

Investment funds are managed by experienced professionals who make investment decisions on behalf of the investors. These fund managers are experts in their field, aiming to achieve capital gains and positive returns for the investors. Their expertise often leads to better returns and more effective risk management.

Cost Efficiency

Investment funds offer economies of scale, reducing transaction costs for individual investors. The pooled capital allows for bulk purchases, lowering fees and making it more affordable to invest in a wide array of stocks or other assets.

Access to a Range of Assets

Investment funds provide access to asset classes that may otherwise be out of reach for individual investors. The collective capital enables purchases of assets requiring large sums of money, such as commercial property or certain stocks.

Liquidity

Investment funds are liquid investments, allowing investors to withdraw their money whenever desired. The redemption process is relatively quick and straightforward, providing investors with access to their funds within a few days.

Transparency and Regulation

Investment funds are highly transparent, allowing investors to thoroughly analyze their performance. It is easy to find information on how a fund compares to its benchmark or reference index and to other similar funds. Additionally, investment funds are regulated and supervised by financial authorities, providing an extra layer of security for investors.

Tax Advantages

In some jurisdictions, investment funds offer tax advantages. For example, transfers between funds may be exempt from personal income tax, allowing investors to defer taxes until the end of their investment journey.

Convenience

Mutual funds, a type of investment fund, are easy to buy and understand. They typically have low minimum investment requirements and are traded only once per day, eliminating intra-day price fluctuations. This makes them a convenient option for investors seeking a simple way to invest their money.

Investment fund disadvantages

Investment funds are a way of investing money with other investors to benefit from the advantages of working as a group, such as reducing investment risk, hiring professional investment managers, and benefiting from economies of scale.

However, there are several disadvantages to investment funds, including:

High fees

Investment funds can charge high fees, including ongoing management costs, transaction fees, and other one-off costs. These fees can reduce overall investment returns. Some funds charge "12b-1 fees", which are used for advertising and sales. These fees are disclosed in the fund prospectus but can be onerous. Funds may also charge high expense ratios and sales charges, which can get out of hand if not monitored carefully.

Tax inefficiency

Mutual funds distribute capital gains to investors as a taxable event, and these distributions can be difficult to predict. This can create an uncontrollable tax event for investors.

Poor trade execution

Investment funds are traded only once per day at the closing net asset value (NAV). This can be a disadvantage for investors seeking faster execution times, such as those with short investment horizons or those engaging in day trading or timing the market.

Lack of liquidity

While investors typically have access to their cash the day after selling a mutual fund, this is slower than ETFs, stocks, and closed-end funds, which require a two-day waiting period.

Management abuses

There is a risk of management abuses, such as unnecessary trading, excessive replacement of assets, and selling losing stocks before the end of the quarter to fix the books.

Loss of owner's rights

Investors in collective investment vehicles often lose the rights associated with individual investments within the fund, such as the right to attend a company's annual general meeting and vote on important matters.

Investment fund risks

Investment funds are a way of investing money alongside other investors, allowing investors to benefit from the advantages of working as part of a group. These advantages include the ability to hire professional investment managers, who may offer better returns and more adequate risk management, as well as benefiting from economies of scale, i.e., lower transaction costs. However, there are several risks associated with investment funds that prospective investors should consider before making any investment decisions.

Firstly, it is important to understand the relationship between risk and return. Generally, investors must take on greater risks to achieve greater returns. However, taking on additional risk does not always lead to higher returns, and investors must be comfortable with experiencing periods of underperformance in the hope of achieving higher returns over the long term. Those who have a lower tolerance for risk may have a smaller chance of making high earnings but also a smaller chance of incurring significant losses.

Secondly, all investments involve varying degrees of risk. There is a possibility that the value of a fund's underlying investments may fall, leading to a decline in the fund's unit price. If an investor chooses to sell their investment at that time, they may incur a loss, receiving back less than they initially invested. This risk is often referred to as capital risk.

Thirdly, currency risk is another important factor to consider. If the currency of a fund differs from that of the investor, or if the fund invests in securities denominated in currencies other than its base currency, changes in foreign currency exchange rates may adversely affect the value of the fund's investments and income.

Additionally, emerging markets and increased political or economic issues can pose risks to the performance of a fund. Funds that invest in emerging markets or regions with political or economic instability may face greater risks.

Furthermore, the use of borrowing or derivatives by some funds to increase potential returns can magnify both gains and losses. Investors should carefully consider the policies and strategies employed by each fund, as these techniques can increase investment risk.

Another risk to consider is diversification risk. Investing in a small number of assets or a single asset class or market can expose an investor to the risk of underperformance. By investing in a broader range of assets and markets, investors can help mitigate this risk.

Liquidity risk is also a factor to consider. Investment funds involve two levels of liquidity risk: the investment manager's ability to buy or sell positions for the fund, and the individual investor's ability to buy or sell units in the fund. If the fund or the investor needs to sell and there is no buyer, this can create a liquidity issue.

Lastly, there is market risk, which is the risk of investing in a market that may decline in value. When a fund is exposed to a single country market, potential volatility increases.

It is important to note that these are just some of the main risks associated with investment funds, and individual funds may have their own unique risks. Prospective investors should carefully consider their risk tolerance, investment goals, and conduct thorough research before making any investment decisions.

Investment fund fees

When investing in a fund, you may encounter various charges and costs that impact your overall returns. Here are some common types of investment fund fees:

• Initial or Entry Charge: This is a one-time fee charged when you first invest in a fund, and it may be included in the price when you buy into the fund.
• Redemption or Exit Charge: This fee is deducted from your investment proceeds when you withdraw your money from the fund.
• Switching or Exchange Fee: If you decide to move your investment from one share class or fund to another within the same fund family, you may incur a switching fee.
• Annual Management Charge (AMC): Paid annually, this fee covers the fund manager's cost of managing the fund and is usually calculated as a percentage of your investment.
• Registrar Fee: This fee covers expenses related to maintaining the register of shareholders, distributing income, publishing reports and notices, and other administrative tasks.
• Custody (Safe-Keeping) Fee: Charged by the depositary and custodian, who are responsible for legally owning and safekeeping the fund's property and assets.
• Audit Fee: Covers the expenses of the fund's auditors.
• Regulatory Fee: Paid to financial regulatory authorities, such as the Financial Conduct Authority, to cover the cost of oversight and compliance.
• Portfolio Transaction Costs (PTC): These are the costs associated with buying and selling investments within the fund, including redemption fees, transfer fees, and broker commissions.
• Performance Fee: Some funds charge a performance fee if they meet certain predefined investment targets. This fee is paid in addition to the standard management fees.

It's important to note that not all funds charge the same set of fees, and the specific fees applicable to your investment will depend on the fund you choose. Additionally, funds may have different share classes, and the fees can vary between these classes.

When evaluating investment fund fees, it's essential to consider the impact of compound interest over time. Even a small difference in fees can result in a significant difference in your returns over the long term. Therefore, it's crucial to carefully review and understand the fee structure of any investment fund before committing your money.

Frequently asked questions