Investment Funds Uk: What Are They?

Investment funds are a popular option for both new and experienced investors in the UK. These funds pool money from many individuals, and use it to buy a range of assets such as stocks, bonds, property, cash, commodities, and even other funds. The fund manager then invests the money in a wide range of assets, and each investor is issued units, which represent a portion of the holdings of a fund. Investment funds are generally considered lower risk than investing in a single company, as they allow investors to diversify their holdings and spread the risk.

Investment funds vs. individual savings accounts (ISAs)

Investment funds and Individual Savings Accounts (ISAs) are both investment options available in the UK. While investment funds pool money from multiple individuals to invest in a diverse range of assets, ISAs are tax-efficient savings accounts that allow individuals to save or invest a certain amount annually without paying taxes on the returns. Here is a detailed comparison between the two:

Investment Funds

Investment funds, also known as mutual funds, are a type of investment where money is collected from multiple individuals and then invested in various assets such as shares, bonds, and property. The fund manager makes investment decisions and actively manages the underlying investments. Investment funds offer diversification and spread risk across multiple assets. They are suitable for long-term investment goals and typically have a minimum recommended investment horizon of 5 years.

Individual Savings Accounts (ISAs)

ISAs are a popular investment vehicle in the UK, offering tax advantages to residents. There are currently four types of ISAs: Cash ISA, Stocks and Shares ISA, Innovative Finance ISA, and Lifetime ISA. Each type has its own characteristics and investment options.

• Cash ISA: This type of ISA holds cash deposits and some National Savings and Investments products. It functions like a regular savings account but with the benefit of tax-free interest. Cash ISAs are low-risk and suitable for short-term savings goals or emergency funds.
• Stocks and Shares ISA: This ISA holds investments such as shares, stocks, bonds, mutual funds, or exchange-traded funds (ETFs). It is similar to a regular investment account but provides tax-free returns. Stocks and Shares ISAs are higher-risk but offer higher potential returns compared to Cash ISAs.
• Innovative Finance ISA (IFISA): This ISA allows individuals to invest in qualified peer-to-peer lending and crowdfunding platforms. It offers potentially higher returns than other ISA options but also carries higher risk.
• Lifetime ISA (LISA): The LISA is a type of ISA that enables individuals to save for their first home or retirement. The government adds a 25% bonus to the savings, up to a certain limit. LISAs have age restrictions, and there are penalties for withdrawing funds for purposes other than those specified.

Key Differences

The main difference between investment funds and ISAs lies in their structure and tax treatment:

• Investment Funds: These are actively managed investment vehicles that pool money from multiple investors to invest in a diverse range of assets. They offer diversification and spread risk.
• ISAs: These are tax-efficient savings accounts with annual contribution limits. They provide tax advantages, allowing individuals to save or invest without paying taxes on interest, income, or capital gains.

In summary, investment funds and ISAs offer different approaches to investing in the UK. Investment funds focus on pooling investor funds and diversifying investments, while ISAs provide tax-efficient savings and investment options, making them attractive for different types of financial goals and risk appetites.

Active funds vs. passive funds

Investment funds are ready-made baskets of investments. People invest in funds because they provide access to lots of underlying investments in one go and are lower risk than buying shares in individual companies.

There are two main types of investment funds: active funds and passive funds.

Active Funds

Active funds are a type of investment fund where the investments are managed by professionals. Active fund managers try to ''beat the market' rather than replicate the average return for a particular index. They do this by actively buying, holding and selling stocks. The fund manager's skill determines the fund's performance, and they may make higher-risk choices in an attempt to outperform the index.

The pros of active funds include:

• Potential for higher returns
• More flexibility in investment choices, such as ESG (environmental, social and governance) funds
• Active managers can limit losses in falling markets by increasing their allocation of cash or lower-risk assets

The cons of active funds include:

• Higher fees to cover the expertise and resources required
• Dependence on the fund manager's skill
• Higher volatility as performance is dependent on a concentrated basket of shares

Passive Funds

Passive funds, also known as 'tracker' or 'index' funds, aim to replicate the performance of a specific market index. For example, a fund tracking the FTSE 100 will buy shares in all 100 companies in the index and in the same proportions as their market value. Passive funds do not try to beat the market, they simply aim to match it.

The pros of passive funds include:

• Lower fees as replicating an index is more straightforward than stock-picking
• Less reliance on the fund manager's skill, as investors will receive the average return for the index as a whole
• Decreased risk as passive funds invest in a diverse portfolio of hundreds of shares
• Transparency, as investors know the underlying holdings of passive funds

The cons of passive funds include:

• No scope for outperformance
• Limited protection in market downturns as passive funds cannot reallocate their portfolio
• Lack of flexibility, for example, in investing in certain sectors such as ESG
• Weighting by market capitalisation can result in a small number of companies having a disproportionate impact on the fund's performance

Both types of funds have their advantages and disadvantages, and the right choice depends on your investment goals and risk tolerance. Active funds may be suitable for investors seeking higher returns and flexibility, while passive funds offer a low-cost, diversified option. However, it's important to remember that past performance is not a reliable indicator of future results, and you should carefully consider your financial situation, goals, and risk tolerance before investing.

Income units vs. accumulation units

Once you have chosen an investment fund, you can select either the income or accumulation version of the fund. The type of unit you hold determines how any income generated from the fund's underlying investments is treated.

Income Units

With income units, income is paid out to fund holders as cash. This could provide the investor with a regular income stream, or the cash could be reinvested to buy additional units. Income units are often used by retirees to increase their pension payments.

Accumulation Units

With accumulation units, income is retained within the fund and reinvested, increasing the price of the units. Accumulation units are designed to offer growth in the fund. Generally, for investors who wish to reinvest income, accumulation units offer a more convenient and cost-effective way of doing so.

The decision to buy income or accumulation units depends on your goals. If you need the income now, income units may be the right choice. If you don't need the cash now and are more interested in long-term growth, accumulation units may be preferable.

Open-ended investment funds vs. closed-ended investment funds

Investment funds are a popular and convenient way to invest in a diversified portfolio. They allow individuals to pool their wealth with other investors to buy a combination of different assets, creating a portfolio run by expert managers or tracking specific indices.

Open-ended investment funds

Open-ended funds allow investors to buy as many 'units' as they wish. The fund grows or shrinks depending on investor demand, with new units created or cancelled when individuals buy or sell them. The two most popular types of open-ended funds in the UK are authorised unit trusts (AUTs) and open-ended investment companies (OEICs). The value of a unit in an OEIC or AUT is linked to the net asset value (NAV) of the underlying assets held in the fund. If the value of these assets moves, so does the value of an individual unit.

Open-ended funds are traded at times dictated by fund managers during the day. There is no limit to how many shares an open-ended fund can offer, meaning shares are unlimited. Shares will be issued as long as there is demand for the fund. So when investors buy new shares, the fund company creates new, replacement ones.

Prices for open-ended funds are fixed once a day at their NAV and reflect the fund's performance. This value is the fund's assets minus its liabilities. This is the only price at which fund shares can be purchased that day.

Closed-ended investment funds

Closed-ended funds have a fixed number of shares offered by an investment company through an initial public offering (IPO). After the IPO, shares are listed on an exchange. Investors can purchase shares through a brokerage firm on the secondary market. Closed-ended funds can be traded at any time of the day when the market is open. They can't take on new capital once they have begun operating.

Closed-ended investment shares reflect market values rather than the NAV of the fund itself. That means they can be purchased or sold at whatever price the fund is trading at during the day. Demand is what drives share prices. Since market demand determines the price level for closed-ended funds, shares typically sell either at a premium or a discount to NAV.

Open-ended vs closed-ended investment funds

Both open-ended and closed-ended investment funds are professionally managed and achieve diversification by investing in a collection of equities or other financial assets rather than in a single stock. They both pool the resources of many investors to invest on a larger and wider scale.

However, there are significant differences in the structure, pricing and sales of open-ended and closed-ended funds. Open-ended funds are more common than closed-ended funds and are the bulk of the investment options in company-sponsored retirement plans, such as 401(k) plans.

Open-ended funds must maintain ample cash reserves to meet shareholder redemptions. Since these funds must be kept in reserve and not invested, their yields can be lower, all else being equal. Open-ended funds typically provide more security, while closed-ended funds offer bigger returns.

Investment funds and tax

When considering investment funds, it is important to understand the tax implications to make informed decisions. Here is a detailed overview of the tax considerations related to investment funds in the UK.

Taxation on Investment Profits

Any profits made from investments are typically subject to tax. However, there are exceptions. If you are investing through an Individual Savings Account (ISA) or a Self-Invested Personal Pension (SIPP), your investments are sheltered from tax. These wrappers provide tax advantages, allowing you to invest a certain amount each tax year without paying tax on the returns. For the 2023-24 tax year, the ISA limit is £20,000, while the annual limit for pension contributions is £60,000.

For other types of investments, the amount of tax you pay will depend on your personal tax situation and the profit amount. If you receive income through dividends or interest payments, you may need to pay income tax. The rate varies based on your income tax band and allowances. Basic-rate taxpayers have a Personal Savings Allowance of £1,000 per year, while higher-rate taxpayers have an allowance of £500. Additional-rate taxpayers do not receive any Personal Savings Allowance.

Dividend Tax

If you receive income through share dividends, dividend tax may apply. Dividends are portions of a company's profits distributed to shareholders. You don't need to pay tax on dividend income within your personal allowance. Additionally, there is an annual tax-free dividend allowance, which is £1,000 for the 2023-24 tax year. The tax rate on dividends above this allowance depends on your income tax band.

Capital Gains Tax (CGT)

CGT is payable on the profit or gains realised from selling investments that have increased in value over time. For example, if you sell shares purchased for £2,000 for £10,000, resulting in a capital gain of £8,000, you may have to pay tax on this profit. The CGT allowance for the 2023-24 tax year is £6,000, dropping to £3,000 from 6 April 2024. You typically won't need to pay CGT on gifts to your spouse, civil partner, or charity, as well as certain assets like UK government gilts or Premium Bonds.

Stamp Duty on Shares

When purchasing shares, you may be subject to stamp duty, which can be calculated differently depending on how you acquire the shares. If you use a stock transfer form for transactions over £1,000, you'll pay stamp duty at a rate of 0.5%, rounded to the nearest £5. Alternatively, if you buy shares electronically through the CREST system, you'll pay Stamp Duty Reserve Tax (SDRT) at a rate of 0.5%, deducted automatically from your purchase.

Tax-efficient Investments

To minimise the tax burden on your investments, consider the following tax-efficient options:

• ISAs: You can save into an ISA without paying tax, up to the annual limit. You can choose between a cash ISA, stocks and shares ISA, or an innovative finance ISA.
• Pensions: When you save into a pension, the government provides tax relief on your contributions. Basic-rate taxpayers receive an extra 20%, while higher and additional-rate taxpayers get 40% and 45%, respectively. However, note that you'll typically pay income tax on pension withdrawals above your 25% tax-free allowance.

It is always recommended to consult with a tax adviser to understand the specific tax implications of your investment choices and ensure you're making informed decisions.

Frequently asked questions