Everything you need to know about investing in funds

Lots of first-time investors may find investing through funds is a good place to start. In this article, we’ll explain the benefits of investing in funds, investment trusts and exchange-traded funds (ETFs).

There are thousands of funds on offer that invest in different countries, business sectors or types of investment - you just need to find the right one (or ones) for you.

The fact funds have their money spread across lots of different investments means it’s a great starting place for someone new to investing, rather than buying individual company shares. That’s because nearly all of them give you instant diversification. Rather than buying one or two company shares yourself, a fund will give you access to a basket of many different companies - typically between 20 and 200 - and sometimes even other assets like property, bonds and commodities.

If something goes wrong with an individual company share, you’ll feel the pain in your portfolio. But if something went wrong with one of the companies in a fund’s portfolio, it would have lots of other companies hopefully doing well to help cushion the blow.

Active vs passive funds

Investors can purchase two main types of funds - active and passive. Active funds are run by a professional fund manager who selects the investments and aims to beat a benchmark index or outperform the broader stock market.

We all lead busy lives, so the ability to delegate the day-to-day running of your money to a professional fund manager, paid to help your wealth pot grow, is a major attraction.

Passive or ‘tracker’ funds differ from active funds in that they mirror or track the performance of a benchmark or index, such as the S&P 500 or companies in America or the FTSE 100 index of the largest UK companies. These typically have lower charges than active funds and are growing in popularity as investors seek the lowest cost option for their investments.

Funds vs investment trusts

Funds are different to investment trusts. A fund will create new units when someone invests money or it will cancel units when someone withdraws their cash, which is why they are often also called an ‘open-ended fund’. Managers who run these funds have to deal with inflows and outflows of investor money, as well as deciding what to have in the portfolio.

In comparison, investment trusts fall under the category of ‘closed-end fund’. They have a fixed number of shares in issue and investors wanting to get involved have to buy shares from another investor. When an investor wants to get out, they sell their shares to someone else. This exchange means the fund manager doesn’t have to manage any inflows and outflows of money and they can concentrate purely on running the portfolio.

Key points to consider

The price of an open-ended fund will match the value of the underlying assets. It’s different with investment trusts where the price is dictated by supply and demand. This means their shares can trade at a discount or a premium to the net asset value of the underlying portfolio.

While buying an investment trust at a discount is typically regarded as bagging a bargain, there are often reasons why a trust languishes on a discount which may give you pause for thought.

Trusts trading at a premium to net asset value aren’t that common. Where they do swap hands for more than the underlying net asset value, this usually reflects strong investor demand to access the skills of the manager, the strategy or the asset class in question.

Another key difference between trusts and funds is that investment trusts can borrow money for additional investment. This is known as ‘gearing’; there are strict limits on how much gearing an investment trust can employ.

Gearing can magnify returns when markets rise, assuming the trust earns a return on borrowed money that is higher than the interest it pays on its loan. When markets fall, you can expect the shares of a geared trust to fall further than an ungeared trust.

What is an ETF?

Exchange-traded funds or ETFs are growing in popularity as a simple, low-cost tool for getting access to a range of companies, commodities and countries. They are like funds in that they invest in a pool of investments and provide exposure to a particular theme or market.

Like investment trusts (but not funds), ETFs trade on a stock exchange, and you can buy or sell them at any time during trading hours at the price shown (with the price changing in accordance to demand). Conversely, investment funds are only priced once a day.

ETFs are transparent. Unlike a fund or investment trust, whose manager might be reluctant to reveal their holdings and tactics, you can generally see what ETFs are investing in because the vast majority track a specific index, such as the FTSE 100 or S&P 500. They will clearly state the name of each index, so you can easily check how that index is constructed via a quick search on the internet.

In recent years, ETFs have become increasingly popular with investors, in part due to their low costs but also because of the fact many active fund managers fail to deliver higher returns than their benchmarks. This is despite charging higher fees that eat into investor returns.

Potential places to start

If you're new to investing, you might want to look at an ETF which tracks a basket of shares in different parts of the world. You can check out the AJ Bell Favourite funds list to get a slimmed down list of funds that have been selected by our investment experts. You can filter this list based on whether you want the fund to be active or passive and where in the world you want it to invest.

If you wanted a tracker that invests in different companies across the world, you could look at Fidelity Index World Fund, for example, which has a low charge of 0.12% a year and tracks the performance of the MSCI World Index of global companies. Equally, you could opt for the HSBC FTSE All-World Index Tracker Fund C Inc, which also has a low charge of 0.13% and tracks the FTSE All-World Index of global companies.

Alternatively, you could drill down into one country, such as the UK or the US and you could opt for different investment styles, such as responsible funds or funds that aim to generate an income.