Investment funds: what are they and how to invest in funds?

To understand what an investment fund is and how it works, it’s important to know terms like net asset value, shares, management company, and custodian. These terms help define this investment option, known for its flexibility and tax benefits.

In this article, we’ll introduce you to everything you need to know about investment funds and make an informed decision about whether this asset is right for your needs.

What is an investment fund?

Investment funds are collective investment vehicles managed by a professional manager. In simple terms, a group of investors gives these managers the authority to invest their money according to a specific plan with clear objectives (i.e., to follow a benchmark or outperform one).

Investors pool their money together and are entitled to the fund’s returns, which can be in the form of passive income (interest, dividend payments) and capital appreciation, depending on the fund’s assets.

Typically, investors buy shares in the fund.

What does an investment fund invest in?

Investment funds can invest in a wide array of assets: stocks, bonds, currencies, and even physical goods, such as real estate or commodities (i.e., raw materials, gold, and more). This variety makes them a good choice for diversifying your investments.

However, each fund has its own investment philosophy that guides what it can invest in. This philosophy determines the types of assets, geographical focus, and risk level of the fund.

Typically, you should check the fund’s prospectus to find out more about it. Some examples of key information include:

• The fund’s assets
• Regions
• Investing strategy and risk level
• Past performance
• Costs

There are also many other sources of information for investors, such as Morningstar, ideal for comparing different funds.

Choosing the right fund can be overwhelming given the wide range of options. If you need help, a financial advisor can guide you in developing a strategy that best suits your needs.

What elements make up an investment fund?

To understand an investment fund, it’s important to know its main components and the roles of those involved.

Fund shares

Shares are the pieces that make up an investment fund. Unlike company shares, these do not have voting rights. Based on the type of fund, these shares can be bought or sold on the stock exchange. Exchange-traded funds can be traded just like stocks, while mutual funds do not trade on the stock exchange; instead, you can buy or sell shares in mutual funds once per day, at the end of the trading day, once the value (net asset value, or NAV) of the fund is calculated.

Investors in a fund

Investors can opt to invest in a fund. They participate in the fund’s returns based on the proportion of the investment.

Net asset value

The net asset value is the value of each share’s portion of the fund’s underlying assets at the end of the trading day. This may be different than the market price of the fund’s share (i.e., an ETF may trade below or above its NAV).

In the case of mutual funds, the NAV per share is calculated daily and is the price you’ll pay to buy the shares (or the amount of money you receive if you sell the shares). For ETFs, they also calculated their NAV daily, but since they trade just like stocks, they also estimate their NAV throughout the trading day. Most if not all ETFs trade at a premium or discount to their NAVs, which allows investors and traders to identify trading or buying opportunities according to their strategy.

Types of investment funds

In general, funds can be split into mutual funds (traded only once per day, at the end of the trading day, once NAV is calculated) and exchange-traded funds (ETFs) which can be traded at any time during trading hours, just like stocks.

Then, based on the fund’s assets or strategy, these can be:

• Money funds
• Fixed income funds
• Mixed funds
• Equity funds
• Guaranteed funds
• Indexed or passive management funds
• Funds of funds
• Pension funds
• Hedge funds

Next, investment funds can be actively or passively managed. Active funds are those that try to outperform the market or a benchmark (such as an index), while passively managed funds typically track a specific market or index and aims to replicate its performance.

In addition, some funds are accumulation funds (where income like dividends, for instance, is reinvested) or distribution funds (income is distributed to investors).

Funds may invest in certain sectors, such as technology or healthcare, or track a broad index like FTSE100. There are some global funds, emerging market funds, and many more types.

Management investment company

The management company is responsible for managing the investment fund. It should be clarified that it is not the owner of the fund, the owners are always the investors. The management company decides where to invest the fund’s assets, that is, it determines the fund’s investment strategy and objectives and executes the trades.

Each investment fund is managed by a single management company, although within that company, there could be a team of people involved in the fund’s management. A management company can oversee multiple funds at the same time.

The management company typically charges a fee for its services, known as the management fee. This fee is taken directly from the investment fund’s assets, reducing the overall return for the investors. The fee covers the costs of managing and administering the fund.

Fund’s depositary

The role of the depositary is to safeguard the assets that make up the fund. In the UK, the depositary must be independent (i.e., not part of the management company). In case of insolvency of the management company, the assets are separated, hence they remain safe.

In the UK, the depositary must also oversee the manager’s operations, and the fund’s cash flow, among other responsibilities. However, the depositary does not make any investment decisions.

What are the main features of investment funds?

Having clarified the concept of an investment fund, it is important to have a better understanding of its characteristics. These are the general characteristics of the funds:

• It invests in a basket of assets, pooling together the money of many investors.
• It is managed by a professional manager.
• It can be a diversified investment (i.e. if the fund invests in different sectors or markets).
• Funds are regulated entities.
• Money may be protected by the FSCS (as long as the company is registered with it)

Investing in a fund: what does it mean?

Investing in an investment fund is straightforward. The investor simply buys shares in the fund using a brokerage service, just like other investments.

The management company takes that money and invests it in various assets according to the fund’s investment strategy, creating a portfolio. When an investor buys shares, they are essentially owning a piece of this portfolio.

If the fund’s investments do well, the value of these shares increases. Conversely, if investments perform poorly, the share value decreases.

The number of buyers or sellers may also affect the fund’s performance.

How an investment fund works: example

Let’s assume a fund has the following characteristics:

• Value of a share: £100
• Number of participants: 100
• Number of shares per participant: 50

Let’s start by calculating how much money the fund has:

Fund’s assets = £100/share x 100 shareholders x 50 shares/shareholder = £500,000

Total number of shares in circulation = 100 shareholders x 50 shares/shareholder = 5,000 shares.

Essentially, the fund has £500,000 to invest in different assets, depending on its strategy and objectives. Once invested, the value of the assets varies, just like with other investments, based on market dynamics and other factors. Hence, the NAV is calculated to find out the actual value of the fund’s assets.

How do buyers and sellers affect a fund?

When new investors buy shares of the fund, they are essentially injecting more money into it. This additional capital gives the fund more resources to invest in various assets. More money in the fund can also provide benefits like reducing overall costs as a percentage of the fund’s assets. However, the buying activity itself doesn’t directly affect the value of the existing shares.

When investors sell their shares, the fund needs to give them their money back. To do this, the fund may have to sell some of its assets. This can sometimes affect the fund’s performance, particularly if the fund has to sell assets at a less-than-ideal time. Again, the act of selling shares doesn’t directly affect the value of the remaining shares, but selling assets to provide refunds can influence the fund’s overall value.

It’s important to note that the buying and selling of shares can change the number of shares in circulation, but they don’t directly affect the performance of the fund’s investments. What truly impacts the returns for the investors are the changes in the value of the assets that the fund holds.

What are the fees of an investment fund?

Investment funds usually charge a variety of fees to cover the costs of managing and operating the fund. Here are some common types of fees:

1. Management Fee: This is a fee for the day-to-day management of the fund, including making investment decisions. It is usually a percentage of the fund’s total assets and is paid to the management company.
2. Administrative Fee: This fee covers administrative expenses like record-keeping, customer service, and other operational costs. Like the management fee, it’s often a percentage of the fund’s total assets.
3. Sales Charge or Load: Some funds charge a fee when you buy or sell shares. A “front-end load” is paid when you buy shares, while a “back-end load” is paid when you sell. These are often a percentage of the amount you’re investing or withdrawing.
4. Redemption Fee: Some funds charge a fee if you sell your shares within a certain period, usually to discourage short-term trading. This is different from a back-end load because it usually goes back into the fund rather than to the management company.
5. Expense Ratio: This is the total annual cost, expressed as a percentage of the fund’s average assets for the year. It includes management fees, administrative fees, and any other asset-based costs incurred by the fund, but not the sales charges.
6. Performance Fee: Some funds charge a fee based on how well they perform compared to a benchmark. If the fund does better than the benchmark, the management company might take a percentage of the excess returns.
7. Transaction Fees: These are costs for buying and selling securities within the fund. While not a direct charge to the investor, these costs can lower the fund’s overall return and are therefore important to consider.

It’s crucial to read the fund’s prospectus or key investor information document to understand all the fees involved. Fees can significantly impact the returns you get, so it’s important to know what you’re paying for.

How are funds taxed in the UK?

In the UK, the way investment funds are taxed depends on the type of fund and the investor’s personal circumstances. Here are the key points to consider:

1. Income Tax on Dividends: If the fund pays out dividends, you may need to pay income tax on these payments. The first £1,000 you receive in dividends each tax year is tax-free because of the dividend allowance. Above that amount, basic-rate taxpayers pay 8.75%, higher-rate taxpayers pay 33.75%, and additional-rate taxpayers pay 39.35%.
2. Capital Gains Tax (CGT): When you sell shares of a fund for more than you paid, you make a capital gain. You may have to pay Capital Gains Tax if your total gains, across all investments, are above the annual tax-free allowance (£3,000 in April 2024). The rate depends on your income.
3. Interest Payments: Some funds invest in assets that pay interest, like bonds. Interest is subject to income tax and doesn’t benefit from the dividend allowance. The tax you need to pay depends on your income.
4. Tax-Efficient Wrappers: Investments like Individual Savings Accounts (ISAs) and pensions can protect your fund investments from tax. If you invest in a fund through an ISA, you won’t pay any tax on dividends, interest, or capital gains.
5. Offshore Funds: If you invest in an offshore fund, the tax treatment can be more complex and depends on whether the fund has reporting status with the UK tax authorities. Gains from non-reporting offshore funds are taxed as income, which can result in higher tax rates.

How to invest in an investment fund?

Fortunately, there are many brokers that allow you to invest in funds. Here are some of the best UK brokers that provide access to funds:

• eToro review
• IBKR review
• XTB review

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Investment funds: summary

Investment funds offer an accessible way for individuals to grow their savings. Managed by professionals, these funds pool money from multiple investors to buy a diversified range of assets. Whether you’re looking for income, capital growth, or both, there’s likely an investment fund that fits your needs. However, it’s crucial to understand the fees involved and the tax implications of your investment. Before diving in, consider seeking advice from a financial advisor to make an informed decision tailored to your financial goals and risk tolerance.

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