Here we are at session number 58 , and we’re going to be talking about Funds. I don’t know how many times I have mentioned the word fund in the last 57 sessions of this podcast, plus countless more times in all my videos and at my day job as a financial planner. The concept of a fund is so important to investment success, that I figured it was worth really zeroing in on what a fund is, how it works, and its key benefits.

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But first…

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Introduction

OK, let’s look at funds. They are the primary vehicle for most folks’ investment portfolios. In the old days, people used stockbrokers to manage their money, and the stockbroker would choose individual stocks and shares depending on his mood that day.

The idea of investors pooling their money together is not a new one; it dates back, some say, to the 18^th Century in Holland, but they seemed to come of age in the 1980’s and 90’s when ordinary investors like you and me started to pile money into them. There’s a useful little potted history on Investopedia here.

Speaking of which, the only link you need to remember is the one for the show notes for this session. All the links are there, plus a sort-of transcript. The notes for this session are [right here!]

Everything you need to KNOW

So, let's deal with everything you need to know about funds first, and then we’ll look to the practical steps you should take if you're thinking about investing in this method.

1 – A fund is a collective investment scheme

The whole idea behind a fund is that you, me and thousands of other investors essentially pool our money together. This provide a much larger sum of money to play with. Most of us only have in the order of thousands to invest, but by ganging up, we can be talking millions or even billions. This give several benefits:

Diversification – Having more money means we can buy more things, and more different kinds of things. This is diversification, or spreading the money around. Diversification by definition reduces risk, as if you invest in more things, the chances of losing all your money due to failure of one of the assets is reduced.

Buying Power – Having more money gives you clout. Holding £200 worth of share in a company doesn’t give you much power in the way that company is run, but buying £20million of shares will.

Access to investments – Some investments for sale today have high entry levels. Maybe there’s an investment which requires £500,000 just to get a slice of. On our own that may present a problem for most of us, but together – no problem.

Reduced cost of investing – Those top-end investments are often very low cost compared to retail, off-the-peg type investments. So having more money may actually reduce the average cost of the investments the fund buys.

So together, we are strong. Investing via a collective investment fund makes a lot of sense.

So as an investor in a fund, I hold units or shares in the fund, and the fund itself holds the underlying investments in shares, bonds, property, gold or whatever. I am a unit holder or shareholder in the fund. The price of each unit reflects the price of the underlying units. Mostly. There are some exceptions to that, which leads me on to the second thing you need to know…

2 – There are various types of funds, all with useful attributes

As time has gone on, slightly different mechanisms have been developed which are similar but different in important ways.

Unit Trusts/OEICs/SICAVs – These are the most common type of fund, called open-ended funds. This term ‘open-ended’ means that the fund can create and destroy units or shares as required. So if a new investor puts money into the fund, more units are created. If an investor wants to withdraw her money, those units can be destroyed or sold to someone else.

There are subtle differences between Unit Trusts and OEICs (Open-Ended Investment Companies). The former is set up as a trust, as the name would suggest and so operates under trust law, whereas an OEIC is a company and therefore operates under company law. The practical differences are negligible as far as any investor would ever be aware of. A SICAV is just a European version of an OEIC really.

The price of a unit, as I mentioned just now is the total assets of the fund divided by the number of units or shares in existence, called thee Net Asset Value. Some Unit Trusts still have two prices, an offer price at which you buy the units and a bid price and which you sell them. The bid price is usually lower than the offer price and the difference between the two represents a kind of initial charge for investing in the fund. This can be 5% or even higher. Thankfully, the industry is moving away from these kinds of charges, so most funds these days are single priced.

Investment Trusts – Similar to OEICs but different in important ways are Investment Trusts. These are still collective funds, structured as companies. They are often called closed-ended funds because the total number of shares in existence for an investment trust is fixed. New investors can only get a slice of the action if someone else wants to sell. This can mean that Investment Trusts are less liquid than OEICs on occasion.

Whereas the value of a share in an OEIC is directly related to the value of the underlying investments, Investment Trusts add in another couple of variables. One is the fact that investor sentiment has a bearing, just as it does on shares in an ordinary company. So if the market thinks that the prospects for the fund are poor, for example, the price of the shares may be below what they are actually worth in terms of the underlying assets owned by the fund. For example, the fund may be worth £100 per share, but the market doesn’t agree, so you can actually buy the shares for just £95. This is called trading at a discount. Conversely if the shares are in demand, the price may be above the Net Asset Value; called trading at a premium.

Finally, Investment Trusts can borrow to invest, whereas OEICs cannot. This is called gearing, and adds another level of risk to the fund. Investment trusts should definitely be considered. Perhaps not when you’re just starting out investing, due to the aded complexity and risk.

ETFs – These are tracker funds whose aim is to mirror the performance of an underlying index or asset class. They are very cheap to run and to buy. I dedicated a whole session to these back in session 50 [LINK] so definitely check that out as a companion to this one.

Mirror Funds – These are the funds you get in more old fashioned life insurance company products like bonds and some pensions. Let’s say you have an investment bond with Standard Life, but within that bond you get access to the Invesco Perpetual High Income fund. This is a very well-known and very successful fund. Well, the verso not the fund you hold will be different because what happens is, Standard Life create a fund whose sole purpose is to invest in the Invesco fund. You’ll see them labelled as SL Invesco Perpetual or similar (SL for Standard Life). This does two things: Introduces a layer of costs and also makes sure the taxation of the fund can be according to life company rules which differ from direct investment into funds. Generally speaking, Mirror Funds don’t offer great value, but sometimes they’re the only option, maybe for a trust investing via a bond.

Funds of funds – Finally let’s mention these which as the name suggests are funds which themselves buy other funds. The purpose of this is to spread the risk around a little wider and to find the best managers in each sector or asset class. This can introduce a layer of costs of course, so watch for that (more about this when we go into what you need to do to win with fund investing)

All these different funds have different uses. Most people will just invest in OEICs, usually within an ISA wrapper to keep the tax to a minimum. But they all have their uses in different situations.

3 – Different classes of share do different things

Not only are there different kinds of funds out there, but very often, each fund will come with different classes of unit or share. It’s important to understand the difference.

The main distinction is between Accumulation and Income shares and this is all to do with what happens to any income produced by the fund. Talking specifically about OEICs here, when a fund holds shares, those shares will produce an income. The fund usually adds up this income produced, say, over a six month period and then pays it out to its shareholders. This payout is itself a dividend and is taxed as such when the shareholders receive it.

Shareholders have a choice whether or not to receive the dividend or to roll it up within their investments to benefit from the compounding effect this brings. But before the shareholders get it, the fund itself deals with the income in two ways, by way of Accumulation and Income shares.

Accumulation shares deal with the income produced by the fund by absorbing it into the share price. So, for example, if a share is worth £100 and the fund produces income of 10p per share, then the share price will become £100.10. The price of each share is boosted by the income produced. If you hold accumulation share and roll up the income like this, you will never see the number of units you hold change.

Income shares work differently. Instead of absorbing the income into the share price, more income shares are created as a result of the income. So, if every shares is worth £100 and the fund produces income of 10p per share, then an extra 0.001 of a share will be given to you for every share you hold. To put it another way, for every 1000 shares you hold, you’ll get another one share as the produce of the income produced by the fund.

It’s important to know that for you the investor the income and tax situation is identical. Many people over my career have misunderstood, and thought that if they held accumulation units, the would be no income to them as far as the taxman is concerned. That’s not the case, just because the income is rolled up, doesn’t mean it doesn’t apply to you. No matter what form of share you hold, you’ll get a tax voucher at the end of the tax year showing the dividend ‘received’ by you in the year which you’ll need to put on your tax return.

Finally a word about some new terms which have entered the fund lexicon over the last couple of years. You’ll hear about ‘clean’ share classes and even ‘superclean’ – the mind boggles!

In the past, the charging structure of funds was quite opaque. You paid, say, 1.75% annual management charge for a fund. This would include, for example, 0.5% commission to your adviser, plus a kick-back of 0.25% to the platform you held the fund on. There would be other costs on top of this too, but I’ll cover these in the next section.

Thank fully the market and the regulator have combined to clean things up quite a bit, so we now have much more transparent charging. A clean fund therefore is a fund where all extras are stripped out leaving just the cot of the fund. Platform and adviser costs are layered on top of that and agreed with you the investor, rather than being dictated to you by the fund house. Superclean funds are funds which have negotiated even lower rates with certain distributor platform due to the scale that the large e platforms can offer. O you might be able to buy the XYZ fund for 0.75% on one platform, but on the bigger platform down the road you might be able to get it for 0.65% charge.

This is all very confusing for investors, which is something I’ll help you with in the next section. But that’s a summary of what you need to know about investing in funds:

Summarise KNOW

#1 – Funds are collective investment schemes, pooling investors’ money together for greater benefit.

#2 – There are different types of funds with different benefits and attributes, and

#3 – Within each fund there may be different classes of share, which achieve different aims of the fund and the investor.

Everything you need to DO 

So let's deal with everything you need to DO

1 – Establish your reasons for investing.

As I’ve said a few times before, you should always have a reason for investing. No sense in just piling in with no method to it. Likely as not, whatever your reasons, timescale, risk tolerance you’re probably going to end up investing in a fund of some kind, and probably an OEIC. By the way, listen back to Session 16 for more on risk.

Establishing your tolerance for risk is one of the key criteria in putting together a portfolio which stands a chance of achieving what you want it to do. Timescale is another criterion. Only once these have been established can you think about how your money should be invested to achieve your aims within those tolerances. More on this next week.

2 – Go Multi-Asset if you’re starting out

Back in Session 41 I covered in some detail about how I would go about starting to invest from scratch. It’s one of the most popular sessions of the podcast and garnered quite a few comments. In that session I talk about Multi-Asset funds as being a great place to start investing.

The idea behind them is that the fund itself holds not only shares, but also bonds, cash, property, and sometimes alternatives like gold and other commodities. These are usually risk targeted and will come with names like balanced or adventurous so that you can get an idea of how volatile they might be. The managers of the funds will monitor and adjust the weightings between the different assets according to how they feel about the world and investment conditions.

This is a great way of being fairly hands-off with your fund choice, while still obeying the main rule of investing which is to spread the money around.

Some of these multi-asset funds are targeted to a certain date and will reduce the risk of the investments as they approach the date in question, which is even more hands-off. I don’t usually recommend these as with my clients I am very much more proactive and we’ll manage this de-risking together over time. Plus, life gets in the way sometimes and plans change, so a fund which is a bit rigid may no longer serve.

In Session 41 I talk about Passive Multi-Asset funds. Here, the underlying assets held by the fund are trackers and ETFs, as opposed to managed funds. Passive funds are lower cost, but cannot, by definition, outpace the market. Active funds have a manager whose job it is to outpace the market. Only one in four active managers does this consistently. I like Passive investing, but I’m to totally evangelical about it, whereas some advisers are. I am evangelical about costs though, which leads me on to the third thing you need to do…

3 – Look at the costs and charges

Like so many things in the financial services world, costs and charges can seem like a minefield of confusing information. No doubt the industry has made it that way on purpose. Fortunately things are becoming clearer as the regulator cracks down on opacity of charging for everybody’s sake.

You need to be aware of some three letter acronyms:

AMC – Annual Management Charge. Usually a baseline cost for managing the fund, but can include other things like trail commission to an adviser

TER – A now outdated acronym which stands for Total Expense Ratio. As my friend Justin Urquhart Stewart is fond of saying, this name is daft because it isn’t total and it’s not a ratio. It has now been replaced by…

OCF – Ongoing Charges Figure, which should include pretty much all costs, though sometimes fund managers can charge in excess of the OCF, for example charging performance fees, but this is unusual.

The problem is a lack of consistency on fund charging. Most retail funds fall under UCITS rules which unsurprisingly are a set of European standards. But still some 14% of funds fall outside these rules. Apparently the Investment Management Association is consulting on changes which will change how fund charges are expressed yet again. This should make it easier to compare one fund with another.

Needless to say you should keep your costs to a minimum as they are a real drag on performance.

Be aware of something called the Bid/Offer spread which I mentioned earlier, that difference between the price you buy shares in a fund and that at which you sell them. This is essentially an initial charge. It is falling out of favour now – avoid funds like these if possible.

4 – Use a platform

I covered platforms in some depth back in Session 11 and then looked at some specific platform in Session 37. A platform enables you to buy funds from many different fund houses under one roof and makes switching between them easier. There are costs involved with having a platform, but the convenience is often worth the cost Platforms can also offer different kinds of tax wrappers, so you could hold a pension, and ISA and General Investment Account (GIA) all in one place. You’ll be able to log in and check progress.

Summary

So, you know how funds work now, and you know that you should have clear reasons for investing, look at Multi-asset funds when starting out, watch for those costs and consider using a platform to hold your investments in a tidy place.

I genuinely have no idea why anyone would go to the trouble of holding individual shares when there is such a wealth of funds available, covering every conceivable asset class, risk rating and price range.

For a website with so much information on funds, performance, statistics and everything else, check out FE Trustnet. It’s mind blowing how much data they have there, and the site isn’t for the faint-hearted. I use their professional software at work for analysing clients’ portfolios and it’s such a smart piece of kit.

This week’s reviews

[This is where I read the reviews from iTunes]

If you like what you hear on this podcast, please leave a rating or review on iTunes by going to meaningfulmoney.tv/iTunes just like Raising The Standard and Chance Last did last week. This helps others to hear about the show and to subscribe, because it keeps me near the top of the rankings. Or just click the red button…

News

Two and a half pounds lost in my first week of getting serious about shifting this lard. Been poorly too so next to no exercise. This is normally the time when I would comfort eat, so I’m pleased to report that my resistance has been effective! I know that to shift weight effectively, I need to both cut out the crap and exercise. My sluggish metabolism needs both to kick in properly. I’m still really chesty, so hopefully by this time next week that will have cleared and I can get moving again.

Had a lovely email from a listener Steve G this week who has promised to donate £100 if I lose weight for two consecutive weeks, which is awesome, thanks Steve! He also suggested that I set near term goals and then ask you guys to contribute when I hit them, which is a great idea. I’ll also be putting an obvious link on the MeaningfulMoney homepage so that folk can donate easily. More on both of those things next week.

If you didn’t tune in a couple of weeks ago, listener and now client dazandjacs challenged me about my slackness on the weight thing and suggested I combine the weight loss with some fund raising. So that’s what I’m doing. I have set up a JustGiving page at justgiving.com/meaningfulmoney raising money for the Merlin MS Centre in Cornwall.

Next Session Announcement

Next time we'll be talking about Zombie policies. These are policies from life insurance companies that are essentially closed to new business. These firms are being bought up left, right and centre. Do they still represent a good place for you to invest? If you have a question on this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/feedback

Outro

That's it for this session of the MM podcast, I hope it was helpful. If I missed anything or if you have any questions, please leave them comments section below.

I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.