An investment fund is a vehicle used to pool capital, which is invested across a broad range of investments. Each investor will hold a share of the investment fund, thereby creating a degree of diversification not always possible or cost-efficient for individual investors. You will often hear the term “collective investment” mentioned when describing an investment fund.
How does an investment fund work?
As an individual investor, it can be expensive to obtain the best investment advice and fund management services. However, when large groups of investors’ pool their capital into one investment fund, this offers vast benefits of scale. As opposed to each investor taking professional advice, the fund is run by fund managers. Therefore, the cost of employing such skills spreads across the broad investment fund with, in theory, each investor covering a small element of the overall running costs.
What is the purpose of an investment fund?
Due to the vast range of investment funds available, both in the UK and worldwide, different funds cover specific areas with varying degrees of risk. You may be looking for a:
- UK market investment fund for a balanced return
- Utility-based investment fund for income
- Technology-based investment fund for long-term capital growth
Each fund will invest across a wide range of investments in a specific area. As investors have a share in the overall fund, they automatically gain a degree of diversification. It would be difficult, if not near impossible, for individual investors with a relatively small amount of money to replicate this degree of diversification.
As investment funds are very popular with pension plans, it is also vital these investment funds, and their underlying investments, are relatively liquid. This means that when required, investors can sell their shares and switch into cash or alternative investment funds.
What are the types of investment funds?
The main types of investment funds include:
The best way to describe a mutual fund is as an open-ended managed investment vehicle. The funds raised are pooled together and invested across a wide range of investments. Mutual funds are not traded on the stock exchange, and those looking to buy or sell mutual fund units will need to contact the managers directly. Mutual funds are extremely popular with pension providers, as a means of diversifying client pension investments.
Exchange-Traded Funds (ETFs) are similar to mutual funds in that they pool capital together and invest in a broad range of investments. Each investor has a share of the ETF similarly to how mutual funds are split. Unlike mutual funds, where the fund price is normally set at the end of the day, ETFs are tradable on the stock exchange throughout trading hours.
Money market funds
Money market investment funds tend to be open-ended mutual funds. They focus on short-term debt securities (often described as near cash) mostly provided by governments around the world. Stability and income are the core aims of a money market fund. Short-term debt securities and other money market instruments are amongst the most liquid in the investment world.
At first glance, you will probably assume that the money market fund is the least risky, with the hedge fund the riskiest. This is not always the case. It depends upon the underlying investments in which the hedge fund invests. There are some hedge funds which invest in high risk/high return areas of the market while others go for a degree of stability – often taking advantage of technical situations in the market.
While each investment fund type offers a varying degree of risk, there will also be relatively low and relatively high-risk options within each class. Consequently, investors looking to use investment funds have a range of risk and investment profiles to choose from.
UK investment funds
The UK investment fund market has grown significantly in recent years. This form of cost-effective diversification is popular amongst managed or self-invested pension funds. Whatever your particular risk profile, and preferred area of the investment market, there will likely be a UK based investment fund to fulfil your requirements.
The risk/investment profile of a relatively young investor, compared to one who is about to enter retirement, will likely be very different. The younger investor may focus on long-term capital growth with relatively low income. Those seeking to withdraw capital from their pension funds on which to live will often prefer to switch from capital growth based investments to steadier, income-based investments in later years. This offers a degree of stability and income visibility going forwards.
How to buy investment funds
As we touched on above, there are four main types of investment fund, although only ETFs are available on the stock market. Units in hedge funds, money market funds and mutual funds are bought and sold directly with the management/administrators. This brings us onto the different types of investment structure, open-ended funds and closed-ended funds.
Mutual funds are the best example of open-ended funds. As units are bought and redeemed, predominantly directly with the fund administrators, units are cancelled and created to accommodate demand. In essence, the number of units available is fluid and continually changing.
The best example of a closed-ended fund is an ETF which is bought and sold on the stock market, in a similar fashion to company shares. Each ETF will have a fixed number of shares in issue. The price will change according to the value of the underlying investment fund AND supply and demand for the shares.
What are the benefits of regular investment?
Many investment funds will offer the option of regular investment on a short, medium or long-term basis. This may involve a set investment each month which is used to acquire shares/units at the prevailing price. There are many factors to take into consideration here, but the main issue is investment timing.
Even the best investors can get their timing wrong. Therefore, spreading your investment over a prolonged period will help to flatten the peaks and troughs and reduce the risks associated with timing. You will often hear the term “pound cost averaging” which we have demonstrated below.
Total Units Held
Total Units Held
As a consequence of making regular £1000 investments in January, April and July, there were more units acquired when the fund price dropped. Therefore the average cost of investment fund units/shares fell from the first purchase price of £10 down to £7.06. As the lump sum investment was executed via one transaction, there were fewer units bought as the price was £10 at the time. This perfectly illustrates the power of pound cost averaging.
Can I hold investment funds in my pension fund?
Yes. Many people use investment funds as a means of positioning their pension funds for short, medium and long-term requirements. There is a range of investment funds available with a significant variation in risk profile and potential gains/type of returns. It is crucial to ensure that any investment funds held in your pension fund are liquid. As we have seen in recent times, some smaller fund managers have been caught out by a wave of unit sales, leading to a suspension of fund transactions.
The situation with EFTs tends to be a little more straightforward when it comes to liquidity, as they are listed on stock markets. The price will be strongly linked to the underlying value of the investment fund. However, due to changing supply/demand for the shares, they may trade at a small premium or a small discount. It is also worth noting that EFTs can be traded throughout a traditional stock market day, while the price of mutual funds tends to be fixed at the end of each day. Individual mutual fund transactions are executed at the same time each day.
There is considerable variation in risk profiles and types of investment when it comes to investment funds. As a consequence, using investment funds, it should be relatively easy to switch strategies as your situation changes. For example, the traditional risk profile flow for a pension fund would tend to be:
- More focused on long term capital growth in the early days
- Capital growth and income-based in the mid-years
- Focus on stability and income in later years
Any degree of diversification will reduce the volatility of your investments. This can, in theory, hold back capital appreciation in the good times, but also offers a greater degree of stability in challenging markets.