What is a Fund?
As part of our 'Investing in ISAs' series of articles - an introduction to funds
In simple terms a fund is an investment company that pools the money of many individual investors. This money is then invested by the Fund Manager to try and achieve a stated financial objective.
What is the difference between buying a fund and stocks?
The amount you can invest in the Stocks and Shares part of an ISA is limited to a maximum of £7600 per year (See 1st article for more details). An investor can choose to buy shares directly, or to invest in shares via funds. Buying shares directly, however, puts the onus on the individual to carefully research, construct, and monitor a portfolio appropriate to their needs. For most, this will be an exceedingly onerous task, and errors can have severe consequences.
An individual investor can get the benefits of professional management and broad diversification across more issues and global markets than they would be able to research themselves by buying a fund. This limits the risk of a single security harming an investor's portfolio and effectively outsources the research and monitoring tasks.
What should I look for in a fund?
Is the fund actively managed or passive?
Actively Managed
An actively managed fund is one where the fund manager or management team select which stocks to buy from those that fall within their investment remit as stated in the funds Investment objective or remit.
Fees for access to this investment expertise will be higher than those for passive funds, but the investor is saved the time and complexity of stock picking by paying a group of professional analysts to do this for them.
Passive
Passive funds, also known as trackers, are funds that attempt to mirror a given market measure or index buy buying a representative amount of each of the stocks that go to make up that market. They should cost much less than actively managed funds, but beware--some firms charge far too much for passive offerings. One of the cheapest FTSE All Share trackers is Fidelity Moneybuilder UK Index, with a TER of just 0.27% per annum.
What is the fund's investment objective?
Every fund will publish what the financial goal it aims to achieve is in its fund prospectus – this is called the investment objective or remit.
Often, these objectives are written so broadly as to be of limited use, however. To help search through and compare the large number of funds available to an investor, Morningstar groups funds into various peer groups, the Morningstar categories, by looking through to their underlying holdings through time. Here you can see a list of our categories, with each group's performance statistics (the categories are ranked on 3-year returns by default, but you can re-order them by clicking on any column header). The local trade association, the IMA, also has its own set of peer groups, which are generally elected by the fund managers themselves.
How much does it cost to own a fund?
As a third party is looking after the investor's money, there are a number of fees that may be applied to the fund. An investor should carefully consider how these fees might impact the return to their investment. Morningstar analysts have found that costs are one of the most significant predictors of future outperformance, with low-cost funds having a substantial long-term advantage over high cost offerings. You can find comprehensive cost information for any fund on Morningstar.co.uk by clicking on the "fees" tab of its Morningstar report.
Cost of buying
There is often a charge when first making an investment in a fund, this is termed the Initial Charge or Front End Load.
Cost of continued ownership.
The fund provider will charge a fee that covers the day to day running and administration of the fund. The most commonly quoted measure of these expenses in the UK is the Annual Management Fee which is deducted from the price quoted for a fund on a daily basis. However are usually other costs associated with running a fund, and a better representation of the fund's actual operating expenses can be found by looking at a fund's Total Expense Ratio (TER). We put each fund's TER in the upper right-hand corner of its main Morningstar page.
Cost of selling
Some funds also charge a fee when you sell units in that fund, this is termed an Exit Charge or Back End Load. These fees are often levied to encourage long term investment and decrease incrementally the longer you own the fund. Some funds may also charge a "dilution levy" if the firm believes redemptions are significant enough to harm long-term shareholders of the fund. Dilution levies go to the fund and thus its shareholders to compensate them for trading costs associated with redemptions--they are not paid to the management firm.
Rewards for good performance.
In some cases a fund will charge a fee if it provides a certain level of performance over a given time period. These Performance Fees vary greatly in the way they are constructed, and care must be taken to ensure any such structure is sensible.
Advanced Fund Selection
Our goal in this article is to cover the basics, but if you want to learn more about fund selection and portfolio building, the following articles should be of help:
What Do Morningstar Analysts Look for in a Fund?
Five Factors for Successful Fund Investing
The importance of investing for the long term
The Pervasive Problem of Short-Termism
Why Costs Matter: Their Impact May Surprise You.
Evaluating Fund Risk: Beyond Past Performance
Morningstar X-Ray: A Clearer View of Risk
How to Evaluate Bond Funds: Part I
Evaluating Bond Funds, Part II
The Pitfalls of MPT Statistics
