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Investment funds explained

Investment funds are considered one of the best ways for beginners to earn good returns from their money. However, with great returns come equivalent risks, and that level of risk is a major factor affecting an investor’s motivation and willingness to invest. On this page, you’ll learn more about investment funds, how they work and their pros and cons, to help you decide if they are the right type of investment option for you.

The rundown
  • An investment fund is a pool of capital that belongs to multiple investors, and is used to purchase stocks collectively
  • Investment funds purchase ‘baskets’ of shares, offering a diversified portfolio and potentially reducing the risk of loss from shares that fail
  • There are different types of investment funds to choose from, each with their own characteristics and benefits

What are investment funds?

An investment fund is a pool of capital that belongs to many individual investors. This capital is used to invest in stocks, bonds or other financial assets collectively

An investment fund can offer diverse investment opportunities, good management and low fees. Both beginners and experienced investors often choose to put their money into investment funds because they are considered lower risk compared to investing in a single company.

How do investment funds work?

When you put money into an investment fund, you’re essentially purchasing shares. These shares can rise or fall in value. You have no control over which companies shares are purchased in, because investment funds usually have a fund manager who manages every transaction

Investment funds are typically made up of a mix of investments, which means that the fund is diverse in nature. Diversifying is often considered a lower risk investment option, because if one company you have shares in fails, your other shares or investments may be able to make up for that loss. 

What are the main types of investment funds?

The main types of investment funds are similar, in that they allow you to invest in a diversified portfolio. However, understanding the features offered by each type of fund can be helpful if you’re looking to invest in a specific type that has features you find favourable, or that complement your investment goals. The different types of investment funds are as follows:

  • Open-ended funds – institutions that offer this type of fund redeem their shares based on each day’s closing net asset value (NAV), meaning they are only priced once, at the end of a trading day.
  • Closed-ended funds – this type of fund raises money through an initial public offering (IPO), which is similar to when a company goes public and begins trading their shares on the stock market. Closed-ended funds issue a fixed number of shares, and trade on the exchange based on investor supply and demand. They do this while the NAV is being calculated, and may trade at premium or discount.
  • Mutual funds – this is the oldest type of investment fund. The total money invested is pooled and used to purchase baskets of shares. The unique trait of a mutual fund is that shares are priced and sold on a daily basis.
  • Exchange-traded funds (ETFs) – ETFs are listed securities that track an index consisting of portfolios of individual securities. When you invest in an ETF, you’re not picking a specific security, but rather choosing a particular asset class or investment strategy.
  • Index funds – index funds contain securities in a particular index, such as the FTSE 100. They’re a type of investment vehicle, where your money is invested in many different places instead of picking individual securities. Index funds mimic the performance of the index being tracked, rather than trying to beat it, which can generate steady returns and is considered a lower risk investment option.
  • Hedge funds – this type of fund is designed for wealthy investors who are willing to invest high amounts to purchase several types of stock. A hedge fund’s main goal is to generate big returns, regardless of which way the stock market flows.

Pros and cons of investment funds

Pros Cons
Investment funds usually have a fund manager who makes decisions on where to invest your funds. Some investment funds have active managers who buy and sell frequently, which can incur fees for each transaction (more on fees below).
They are considered a lower risk investment option, because investment fund portfolios are diversified, which allows you to own different securities. Some types of investment funds, such as ETFs, aren’t suitable if you want to invest over the short term, because they’re designed to mimic market performance which often provides better returns over the longer term (see graph below).
You can invest any amount you wish in investment funds. Investment funds limit your control because a fund manager manages them. If the fund is investing in a company you don’t like, you’re unable to do anything about it.
Investment funds can be a good option for beginner investors, because they require little management, and you won’t have to make complex decisions on your own. Since investment funds can provide lower risks, the returns you might earn can often be lower than if you invest in higher risk funds, depending on the investment fund you choose and how much risk you’re willing to take.

Which investment fund should I choose?

Determining your investment goals will help you decide which investment fund might be the right choice for you. If you’re looking for the lowest risks on your investment, then you might want to consider investing in an index fund or an ETF. 

If your goal is to gain experience in investing and you don’t want the hassle of choosing your own investments, you could choose to invest in a fund that’s run by a fund manager. 

Which investment fund you choose will come down to your needs, goals and the amount of risk you’re willing to take.

How do I buy and sell investment funds?

To buy into a fund and then sell your shares when you’re ready to do so, you’ll likely need to use a fund supermarket or investment platform. All investment platforms are online and are essentially your one-stop-shop for investing. You can purchase and hold funds using these types of platforms, and they typically allow you access to a wide range of funds. 

Selling funds is just as easy as purchasing them. When you log in to your account, you’ll be able to see all the funds you hold and will usually simply be able to sell them from there. However, you should be aware that funds are typically not sold until the following day. 

Do investment funds charge a fee?

The platform you sign up to will either charge a flat fee or a percentage based on your funds. A flat fee is usually for investors who put over £50,000 into their chosen fund. Percentage-based fees are charged on how much you have in your fund, which means the more you have, the more it may cost you. The fees you’ll incur for using the platform are typically charged quarterly or monthly, and it’s important to check all the fees before you sign up to anything. 

If you have a fund manager, you may be charged an annual management charge. This charge is usually percentage based and averages around 0.75% for most actively-managed funds. The fund manager usually publishes their fees daily, and the fee also reflects the performance of the fund. 

You may also incur fees when you buy and sell funds. This cost varies per platform and can be anything from £5 to £25 per fund you trade. However, some funds don’t charge any fees for these transactions, which is why it’s important to check all of the details of the platform you want to use before you sign up.

What to consider when buying investment funds

When you have determined your investment goals and needs, the next thing you may want to consider is how long you’re willing to invest for. For most investment funds, you can typically acquire better returns if you choose to invest over the long term. However, some investment funds (usually those which are actively managed) can be utilised for short-term investments.

Investment funds vs savings accounts

Although investment funds have the potential benefit of high returns on your investment, they can be a risky option and certainly don’t come with any guarantees. In worst-case scenarios, the risk you’re taking by putting your money into investment funds is losing it all if share prices crash or a company you’ve invested in fails. The graph below shows the performance of the FTSE 100 over the last 20 years. As you can see, the stock market dipped dramatically in the early 2000s, crashed in 2008, and has seen a rapid decline in 2020. 

If you don’t want to take this risk, choosing to invest in safer options, such as savings accounts, might be more suitable for you. 

https://www.londonstockexchange.com/indices/ftse-100?lang=en

Savings accounts, such as fixed rate bonds, offer competitive interest rates, enabling you to grow your savings pot at a much lower risk. With a fixed rate bond, you know how much interest you’ll earn from the day you open the account until the end of your agreed term. Because UK-regulated bonds are protected by the Financial Services Compensation Scheme (FSCS), you can rest assured that your deposits are protected.

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