Investment funds explained

What are investment funds?

Investment funds (known as mutual funds in the US) are collective investment schemes, which pool your money with that of other investors to give you a stake in a ready-made portfolio.

Essentially, your money is spread across dozens or hundreds of different assets across the world, with the fund manager doing all the work.

The fund manager decides what to invest in and changes the holdings where necessary; in exchange you pay them a fee. You make money when you sell your holdings in the fund and from dividends, though dividends can also be reinvested.

Read on to find which funds might suit you best.

Should I invest in a fund?

A fund provides an easy way to access many different shares, bonds and other assets and so diversify your portfolio, a crucial part of managing investment risk.

You could pick shares yourself and avoid paying the fund manager a fee. But that requires time, effort and knowledge in the areas you're investing in. There will inevitably be sectors that you're less knowledgeable about; here, a fund manager's expertise can be worth paying for.

Do note that if you invest in a company through a fund, rather than directly buying its shares, you won't be able to vote in an AGM - the fund manager will vote.

Investors with particular concerns, such as sustainability, should pick a fund manager with policies and a track record in this area (more on that below).

• Find out more: ethical investing explained

What are equity funds?

Equity funds invest in company shares.

Historically, equities have delivered higher returns than safer investments, such as savings accounts and bonds, and can act as the real driver for growth as part of a balanced investment portfolio.

Funds tend to focus on companies in a particular country (such as a UK equities fund), industry (eg healthcare), firms of a particular size (eg small cap funds) or a mix of these factors. Read a fund's Key Investor Information Document (KIID) and Prospectus to find out more.

Other than equities, funds can also invest in:

• bonds and gilts
• commodities, eg gold
• property
• other funds (known as multi-manager funds).

What are tracker and index funds?

Tracker funds track an 'index' - a group of companies, such as the FTSE 100 - by buying all or some of the investments in it. When an index rises, the value of your fund rises with it (after costs). Conversely, when the index falls, your investment in the fund falls with it, too.

These 'passively managed' funds are different from 'actively managed' funds, where the fund manager attempts to beat the performance of the market.

Though beating a market may sound more exciting than tracking it, over the last 15 years less than 50% of actively managed funds have beaten their passively managed equivalents, Morningstar reported in 2022.

This is in large part because tracker funds are far cheaper, sometimes costing as little as 0.1% a year (that's £1 for every £1,000 invested), while active funds tend to charge more, such as 0.5% or more.

That difference might not seem huge, but over time those costs will add up. You'll have to pay fees come rain or shine and an expensive fund will make a bad year even more painful.

Here's how £1,000 in a fund costing 0.1% and a fund costing 1% would perform if both funds grew at a rate of 5% per year:

After five years, the cheaper 0.1% fund would be worth £1,270 and the more expensive 1% fund £1,217 - a gap of £53. After 10 years, the gap would be £133.

What makes a good tracker fund?

The best way to judge the performance of a passive investment fund is to look at its tracking error. This shows how far the fund's performance deviates from the actual index it's tracking.

Of course, no tracker fund will identically match an index, as an annual fee is levied on the funds. A tracking error of 0% would mean perfect replication. A tracking error that is just the cost of the fund is an indicator of an excellent passive investment.

Keep an eye on costs. With so many tracker funds tracking the same high-profile indices (such as the S&P 500), you may be able to find a cheaper fund doing the same job.

What are unit trusts and Oeics?

Unit trusts and open-ended investment companies (Oeics) are two ways of structuring an investment fund.

Unit trust

The fund is split into units, and this is what you'll buy. The fund manager creates units for new investors and cancels units for those selling out of the fund.

The creation of units can be unlimited, hence why the fund is 'open-ended'. The price reflects the value of the fund on the day.

Oeics

Open-ended investment companies (Oeics) operate in a similar way to unit trusts except that the fund is actually run as a company.

It therefore creates and cancels shares rather than units when investors come in and go out of the fund, but they still directly reflect the value of the assets that your fund manager has invested in.

Closed-ended funds (investment trusts)

Investment trusts issue a fixed number of shares when they're set up, which are bought and sold on the stock market.

Unlike both unit trusts and Oeics, the price of an investment trust may differ from the actual value of its holdings (the net asset value, or NAV). Trusts can do some things fund managers can't, such as borrowing money to invest.

• Find out more: investment trusts explained

Exchange-traded funds (ETFs)

Exchange-traded funds are listed on a stock exchange, so you can buy and sell them at any time that the exchange is open.

ETFs can be more transparent, liquid (meaning you can move money in and out of them easily) and flexible than unit trusts and Oeics. Growing in popularity in recent years, they've enabled investors to cheaply access new markets, from beauty products to space exploration.

They tend to be passively managed, and very cost-effective, though some are actively managed and hence more expensive.

Also, because ETFs are traded on the stock exchange, they may incur extra trading fees from investment platforms. If you buy and sell ETFs frequently, these fees can stack up.

How can I make money from funds?

You can make money (a 'return') from funds in two ways: dividends and capital growth.

Dividend payments are the distribution of profits made by companies that the fund owns, usually paid out twice a year.

Capital growth refers to the changing value of the fund. If you sell it for a higher price than you bought it you'll make a profit.

When you buy a fund, you'll usually be given the choice between income units, where dividends are paid out to you in cash, and accumulation units, where dividends are reinvested.

If you don't need the money now, accumulation units can lead to much higher capital growth and hence bigger profits in the future.

Against these potential gains, you need to consider a number of potential costs:

• Ongoing charge figure (OCF) - an annual percentage of your investments you'll need to pay to the fund manager, however the fund performs.
• Performance fees - usually levied by actively managed funds. These typically take 20% of everything above a certain level of performance.
• Trading fees and stamp duty reserve tax - paid when a fund buys or sells a share.
• Exit fees - charged by some funds should you decide to sell your investments.
• Platform fees - levied by the investment platform or financial adviser (more on these below).

You can find out more about fund fees and how they affect your investment performance here.

How to buy and sell funds

The easiest way to buy funds is through an investment platform or an independent financial adviser (IFA).

An IFA can pick investments for you and provide advice on long-term investing strategies and reducing your tax bill.

An investment platform can prove far cheaper. With do-it-yourself (DIY) platforms you'll need to be comfortable picking your own investments, though search tools, news and recommended fund lists are available.

Do-it-for-me platforms have you fill in a questionnaire about your aims, attitude to risk and interests, before picking a range of funds for you. They tend to charge a little more than DIY platforms.

We've surveyed thousands of investors to find the best investment platforms. We also help you to compare investment platform fees and charges.

Buy within an Isa or Sipp

Buying your funds within a stocks and shares Isa, junior Isa, lifetime Isa or self-invested pension plan (Sipp) means you won't pay dividend tax or capital gains tax.

Lifetime Isas also provide bonuses and Sipps provide tax relief.

Most investment platforms don't charge extra for an Isa, though note you can only pay into one of each type of Isa (such as a stocks and shares Isa) per financial year, effectively limiting you to opening one of each type per financial year.

Drip-feeding vs lump sums

Timing the market (buying when prices are low and selling when they're high) sounds great, but it can prove difficult in practice.

Rather than investing a large lump sum in funds at once, you could try 'drip-feeding' also known as 'pound-cost averaging'.

This involves investing a regular amount each month. When fund prices fall, your money will buy you more fund units. When fund prices rise you'll benefit from capital growth.

Most investment platforms will let you set up regular payments, often with reduced fees.

Which funds should beginners invest in?

Funds are a great option for first-time investors as the fund manager can provide investing expertise.

If you know your attitude to risk, consider multi-manager funds. These are funds that invest in other funds, often structured to appeal to investors with a particular risk appetite.

An '80% equities' fund is going to be riskier - but potentially far more rewarding - than a 20% equities fund. Our guide explains more about asset allocation.

Do-it-for-me investment platforms can give you an idea of your risk appetite. You can then go with their recommendations, or switch to a DIY platform and pick your own funds.

• Find out more: are you ready to invest?