What are Mutual Funds?
A fund is a collective investment that pools together money from lots of individual investors. The fund manager then invests the money in a range of investments that align with the fund’s objectives, investment approach and risk level.
Funds come in all shapes and sizes. Some funds invest globally, others look to specialise in certain areas like higher risk emerging markets for example. They give investors access to different asset types like shares, bonds or property, offering an easy way to diversify your investment portfolio which helps reduce risk.
How funds work
When an investor buys a fund, they’re issued with units which represent a portion of the holdings in the fund.
The units are priced based on the value of the underlying investments – also known as the net asset value (NAV). If the underlying investments chosen by the fund manager perform well, this increases the fund’s NAV and therefore the value of the fund’s units. The opposite is true when the NAV falls.
Funds fall into two main categories – Unit Trusts and Open-Ended Investment Companies (OEICs).
On the face of it, they’re both very similar and share lots of the same traits.
For example, both are normally valued once a day and have the same open-ended structure. This means that if there are more investors buying the fund than there are selling, the manager will create new units. And vice versa if there are more sells than buys – the units are cancelled.
But, the main difference between the two types is the way they’re priced.
Unit trusts are normally ‘dual priced’. This means they have an offer (buy) price and a bid (sell) price. The difference between the two prices is called the ‘bid-offer’ spread, which accounts for any initial charges, bid-offer spreads for the underlying holdings, or any other costs like dealing fees and stamp duty.
OEICS, however, typically have the same price for buying and selling. Any charges for the fund are simply added to the price of the fund unit. Most newly created funds are set up as OEICS as it makes the financial accounting and pricing easier for fund management teams.
Types of funds
- Equity funds - Funds that purely invest into individual shares. They tend to focus on long-term growth potential through investing in ‘growth’ companies, or they aim to generate an income by investing in dividend-producing shares. Equity funds can invest in companies of different sizes. Funds that hold investments in small and medium-sized companies offer an exciting, but higher-risk way to grow your wealth.
- Bond funds - Bond funds invest into fixed-interest investments like government bonds or corporate bonds. They’re seen as safer investments when compared to funds that invest into shares, and could help to reduce volatility in a portfolio if markets take a turn. Bond funds could act as a useful building block for investors looking to build an income portfolio.
- Mixed investment funds - Mixed investment funds do exactly what they say on the tin. They predominantly invest into a blend of shares and bonds, but sometimes hold other asset types like commodities or cash, which could be a great option for investors looking for more diversification. The amount invested into each asset type will depend on the fund’s objective and risk level. Cautiously-managed funds are likely to have a higher weighting in bonds. Whereas, you’ll normally find more adventurous funds have a higher percentage invested into shares.
- Index funds - Index tracker funds aim to track the performance of a particular stock market or index - this is called ‘passive’ investing. Where actively-managed funds attempt to beat the market, passive investing is all about matching it. Investing in index tracker funds is a simple way to invest, and as there’s no fund manager wages to pay, it’s cheaper compared to investing in actively managed funds too. Although with passive funds there’s little chance of out-performing the market.
- Property funds - Funds that invest into property which can broadly be divided into three areas: retail, industrial and office. Some property fund managers invest into physical property. Others invest in property company shares. Although property funds help diversify your investments, it’s a specialist area which should only form a small part of your overall portfolio.
- Exchange traded funds (ETFs) - ETFs also aim to track the performance of a particular stock market or index, just like index tracker funds. The main difference being ETFs trade on a live exchange with a live market price so they can be traded at any time during market hours. This offers greater flexibility for investors, but usually attracts additional dealing costs. ETFs can offer investors exposure to markets in hard-to-reach areas, such as precious metals and agriculture.
- Hedge funds - A hedge fund is an alternative investment that, as the name suggests, adopts various hedging techniques. They also use a variety of advanced investment strategies which include leverage and derivatives to help protect the value of investors’ money, and try to take advantage of market ups and downs. Hedge funds tend to be reserved for high net-worth or sophisticated investors as they have expensive management and performance fees.
How do fund dividends work?
Dividend or interest payments for funds are treated differently, depending on the style of unit you hold – income or accumulation.
Income units will pay out any dividends or interest generated from the underlying investments. For those investors looking for a regular income stream, this is the style of unit most investors opt for. The regularity of payouts varies from fund to fund, so you’ll need to check the fund’s Key Investor Information Document (KIID) for more information.
Please note, any income from investments is variable and shouldn’t be recognised as a guaranteed source of income.
With accumulation units any income is retained within the fund and reinvested, which increases the price of the units. This style of unit is better suited for investors looking to grow their wealth over the long term.
All investments can fall as well as rise in value, so you could get less than you invest.
How to invest in funds
You can invest in funds through most stock brokers or investment platforms.
Unlike shares, which trade at a live market price when the market is open, funds are usually traded once a day.
Each fund has a daily ‘valuation point’, normally at 12 noon. At this time the manager works out the value per unit of the fund’s investments. This is the price at which units are bought and sold. If you place an order to buy or sell a fund, it’ll go through at the next valuation point. This means you won’t know the exact price beforehand.
With HL, you can invest in funds from as little as £25 per month through Direct Debit or a lump sum from £100.
Are all funds tax exempt?
Funds held in an ISA or SIPP are sheltered from Capital Gains Tax (CGT) and UK Income Tax as they’re tax-efficient accounts. Funds held outside of these types of accounts will be subject to the normal UK tax rules on investments.
Remember tax rules can change and depend on your personal circumstances. If you’re in any doubt as to the suitable course of action, we recommend you seek tax advice.
This is not personal advice, if you are unsure of an investment for your circumstances, please seek advice.