Introduction to funds

What you’ll learn:

• How funds work
• What the differences are between unit trusts, open-ended investment companies (OEICs) and investment trusts
  
• How the right funds for you depend on your investment timeframe and approach to risk.

Learn in 10 – What is a fund?

Short on time? Watch this 10-second video explaining what a fund is.

The main types of investment funds are unit trusts and open-ended investment companies (OEICs), and investment trusts. They essentially operate in very similar ways but differ in terms of their structure and the way they’re bought and sold. Like any other investment, funds can fall as well as rise in value. You have to accept that if you invest in them, you risk losing money, though, of course, the aim is that you will achieve a decent return. But you have to be prepared to keep your investments for at least five years, or preferably longer.

How do funds work?

When you invest in a fund, your and other investors’ money is pooled together. A fund manager then buys, holds and sells investments on your behalf. All funds are made up of a mix of investments – this is what diversifies or spreads your risk. For example, a UK equity fund is likely to hold a wide number of stocks from a broad set of different British industry sectors.

Funds typically consist of one single asset type, usually either shares or bonds. Some, however, specialise in alternative investments, such as commercial property.

But there are portfolios that have exposure to many different asset types. Multi-asset funds for example can hold a mixture of shares, bonds, property, cash, commodities, and even other funds.

One of the biggest advantages of funds is the wide range of choice they bring to investors. This choice enables you to control risk, diversify across any number of different assets, and access numerous different markets and countries.

Unit trusts and OEICs

The main difference between a unit trust and an OEIC is that an OEIC is established as a company, whereas unit trusts are governed by trust law. With a unit trust you buy units, and with an OEIC you buy shares in the company. Both types of fund work in a similar way because they're 'open-ended' investments. This means that there aren’t any restrictions on the number of units or shares that can be issued, so when new buyers come into the fund the fund manager simply creates more units to meet that demand. When an investor sells, then the units are deleted. The unit trust or OEIC price is normally calculated once a day and changes to reflect the exact value of the investments held in the fund.

As an investor, your holding will rise and fall in value with the movement of the investment fund's underlying assets.

Investment trusts

Investment trusts are structured like a public limited company and are listed on the stock market, so you can buy and sell shares in them as with any other listed company.

Like unit trusts and OEICs, when you invest into an investment trust, your money is pooled together with that of other investors to invest large amounts and reduce costs. The manager of the investment trust makes the decision as to what assets are bought in order to build a diversified portfolio – they can be used as a simple and cost-effective way to diversify your holdings.

However, unlike unit trusts and OEICs, investment trusts are 'closed-ended', which means they have a set number of shares in existence. This means you can only sell your shares if someone wants to buy them.

The Net Asset Value (NAV) is the total market value of all the investment trust’s assets divided by the number of shares in issue. The NAV is typically published on a daily basis.

As their share price will move up and down in line with investor demand, investment trust shares can trade at a discount, or a price which is lower than, their NAV. Equally, if a trust is in demand, they can trade at a premium, or a price which is higher than the fund’s NAV per share.

One of other key differences between an investment trust and a unit trust or OEIC, is that an investment trust manager is legally allowed to borrow capital to make investments. This leverage may increase investment gains but also increases investor risk.

Understand the risks

The type of unit trusts, OEICs and investment trusts you invest in should match both the stage of life you're at – such as how close you are to retiring or the extent of your family commitments, and your investor profile, which reflects how you feel about investment risk.

Equity portfolios are widely viewed as the riskiest type of fund as stock markets can move, both up and down, quite quickly. But there are naturally varying levels of risk – an emerging market fund investing in Chinese equities, for instance, will be seen as a far riskier bet than, say, a vehicle investing in UK blue-chip stocks listed on the FTSE 100.

Bond funds are historically generally much lower risk than equity portfolios, although some are higher risk than others. For example, an emerging market or high-yield bond fund is likely to carry greater risk than a fund that invests in shares of large companies from the UK, US and Europe.

Bonds are essentially IOUs issued by governments and corporations looking to raise cash. When you invest in a bond, you are lending your money for a set period of time, during which the issuer will pay you interest. When the bond matures, you should get your original capital back in full. The main risk is the issuer being unable to pay the interest or repay the loan as a result of, say, going out of business. For that reason, UK government bonds, known as gilts, are seen as much lower risk that bonds issued by corporations.

Is my fund investment accessible?

The short answer is almost always yes. Most unit trusts and OEICs let investors sell their shares or units at any time and you will receive the value of the underlying assets at the time, which may of course be more or less than you paid for it. If you sell an investment trust you will receive the market price which is influenced by supply and demand. This can work for or against you depending on your timing.

Remember that a fund investment requires time to make a return for the investor, although this may not happen even with time – there are no guarantees and you could get back less than you invest.

Make sure you're aware of the full range of costs that you're being charged as these will eat into your investment returns.