Five key things to consider when investing in funds

Funds are an excellent starting point for investors as they can remove the need to research dozens of potential investments.

When you invest in a fund, you are essentially entrusting your money to a professional who will invest it in shares or bonds (company/government debt) on your behalf.

While that removes much of the leg work on your part, you still have to pick a good manager in the first place. That can be quite daunting, particularly if you are new to investing.

With that in mind, here are five key things to consider when you’re investing in a fund, along with some ideas from the EQi list of rated funds, compiled by independent investment research business Square Mile.

1. Fees

Fees are an important first consideration when it comes to investing in funds as they could eat into your long-term profits if you’re overpaying.

The big number you want to look out for is the Ongoing Charges Figure or OCF. This is the overall fee the company managing your money charges.

This is usually expressed as a percentage, for instance ‘0.5%’. So, for example, if your investment is worth £10,000, you will be charged £50 a year.

It’s also worth noting that you might also be charged additional fees when your fund provider trades shares or bonds on your behalf. These are known as transaction fees.

When it comes to deciding how much you’d be willing to pay, this depends on a few things, some of which we’ll cover later in this article.

Fees will vary by whether the fund is actively managed (as in, by an investment professional) or a passive fund, which is controlled by computers and just blindly tracks an index such as the FTSE 100.

Fees will also be higher on funds that focus on more remote areas of the world, such as emerging markets, that are more difficult for managers to research and evaluate.

For instance, the Royal London UK Equity Income fund, which is actively managed has an OCF of 0.72%, whereas the JPM Emerging Market Income fund costs 0.90%.

2. Active vs passive

Investment funds can be broken into two types – actively managed and passively managed.

As stated above, funds that are actively managed have a human manager who makes decisions about what to buy for the fund in order to maximise its performance.

A passive or ‘index’ fund instead buys a selection of all the companies in a particular index, such as the FTSE 100 or S&P 500.

When deciding which to plump for there are a few considerations. First is cost. Active funds tend to charge a higher fee. This is because there is a human making decisions, which requires time and resources to perform.

Passive funds however tend to be very cheap as there is little thought involved; they simply bob up and down with the index they are designed to follow.

The other consideration is potential performance. Actively-managed funds aim to beat the index they benchmark themselves against. For example, a manager might aim to consistently outperform the US’s S&P 500.

Passive funds, on the other hand, will just aim to follow the index they are benchmarked against. That means with a passive fund you’ll never outperform the index, but with an actively managed fund you may beat it. But conversely, you could also underperform the index.

A good example of a passive fund on the EQi rated list is the Vanguard US Equity Index Growth fund, which aims to track the performance of the S&P Total Market Index. The fund charges just 0.1% and has returned 98% growth over five years at the time of writing. A comparative active fund, such as Artemis US Select, has performed even better, returning 123%, but has a much bigger OCF of 0.85%.

3. Sector

There are a vast range of funds out there, some of which focus on very niche industries or on remote parts of the world.

For example, you can get funds that invest in technology, healthcare providers, energy firms but also funds that invest solely in firms based in the UK, Japan and also so-called ‘emerging nations’ such as Vietnam or Thailand.

Because there is so much choice, it can be tricky to decide exactly what you want to invest in.

Different regions offer different benefits and risks. Emerging markets such as China, India and Brazil offer more growth potential than established markets such as the US, UK and Japan. However, they also tend to be erratic, meaning your investments may rise and fall in value regularly.

For instance iShares UK Equity Index (UK) has returned 12.9% over five years but offers an annual yield (income) of 4.67%, whereas iShares Pacific ex Japan Equity Index has returned 54% over five years but only offers a yield of 3.18%.

Similarly, different types of industries confer different advantages. The tech sector, with the likes of Google and Facebook has been the darling of the last decade, but whether that trend continues remains to be seen. Specific funds such as Polar Capital Global Insurance and First State Global Listed Infrastructure exist to take advantage of particular sectors of the economy.

4. Goal of the fund

When picking a fund, understanding the goal of the fund is essential. That goal should typically align with your own goals. For instance, a fund that has a goal of maintaining the value of its assets but offering a significant income will be better for someone who is in retirement than someone who is looking to grow their portfolio over a long time. A good example of this is the Artemis Strategic Bond.

Conversely, a growth-focused fund will not be a good place for someone who can’t afford to take a short-term hit to the value of their savings pot, such as a retiree reliant on it to draw an income. Growth funds, while typically growing the value of an investment over time, may suffer bigger setbacks when markets fall.

There is also a consideration to be made for responsible, or ethical funds, which have become very popular as awareness of climate change has increased. Investors can access the same sectors they prefer but with an ethical bent, such as through Kames Ethical Equity or Trojan Ethical Income.

5. Risk

Finally, and perhaps most important of all, is considering the risk you are willing to take. Risk can be misinterpreted easily as thinking how much of a ‘gambler’ you are, but in fact it is more important to think about risk in the context of your goals.

A young person with many years before retirement can afford to take on greater risk. The value of their portfolio will grow faster, but will also suffer bigger temporary drops. If that same young person opts for a much more conservative investment, it may mean a less risky path, but it will also lead to an inferior outcome for them at retirement.

The risk associated with investing in funds is essentially the sum total of all the above factors. Each facet confers more or less risk on the investment you make. Choosing where you sit on that scale takes some thought, but should by no means dissuade you from taking advantage of excellent investment products designed to help build or maintain your long-term wealth.

New to EQi! The Smart Money, a podcast for self-investors

Listen now